Interest on a Construction Loan
Hi All - technical question for those of you in the weeds underwriting development deals and closing construction financing. A typical structure for a construction loan is that the lender requires all borrower equity to go in first before debt funding starts. As such, all of the capitalized interest is being funded by the lender as part of each draw request. The amount drawn then gets added to the principal balance of the loan (which is of course where the "interest on interest" concept comes into play).
My question: when the lender funds the monthly interest draw, are they actually paying themselves at that point in time (i.e. they get the interest paid to them at time of draw, as if they are moving funds from one pocket into the other) PLUS get it paid back to them as principal at loan payoff, or is the interest draw just a paper transaction and they don't get anything in the way of interest until the loan is paid off?
Perhaps this is a dumb question, but I would think the lender would want to make something monthly as opposed to waiting until end of term/loan payoff to make anything.
Any insight into this? Thanks in advance.
It’s a commercial point to be determined and agreed upon during networking before executing the credit agreement.
Don’t work on lending so not sure what they actually do with the funds, but from a development perspective your interest accrues monthly only on the amount your lender signs off on allowing you to draw, which typically will include interest due to them for that month, which is funded out of a portion of your construction loan proceeds that is set aside for interest payments.
You aren’t really paying “interest on interest” like you’d see in mezz via PIK interest, but rather your construction loan is sized via your total budget and then the reserve is drawn down through term.
But to answer your question, yes, in construction draws you will often see interest paid to lender and the funds are released via them to “pay themselves” in a simple way of looking at it.
I think about it a little differently. You typically size the interest reserve by doing a monthly draw a schedule which shows you paying interest on interest. You estimate a reserve for budgetary purposes but each month you pay interest you are paying interest on the prior interest draws (just like you are paying interest on a hard cost line item).
The bank creates the funds needed for the interest payment by creating a deposit in your account. The accounting mechanics of this are an increase to your loan balance (asset of bank) along with an increase to your deposit account (liability of bank). To book an interest payment, the bank transfers the funds from your deposit account to their equity account.
Whether there are actually cash funds set aside to cover interest by the lender, or it's just "accounting" depends on the lender. I used to work at a debt fund - for loans that were 100% interest reserve, we technically did not get "paid" cash interest until our loan was paid off in full.
The approach a lender actually takes will depend on a number of factors, including their internal capitalization. It should not make a difference from the borrower's perspective, however.
As a developer, when you close on a construction loan, the interest reserve will typically be presented as a “holdback” and reduce the net proceeds available at closing. For modeling purposes, if you know what this amount will be (typically shown in the initial term sheet), you could show it as a separate line item that gets depleted each month as interest and loan draws are made. Once fully depleted you’ll likely need to fund it out of equity each month, or the lender may require you to refill the reserve out of pocket.
I have been seeing more term sheets requiring interest reserves to be “pre-funded” at closing where the funds sit in an escrow account and are drawn upon as needed to pay interest.
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