A rehab project doesn't produce any income while the work is underway — no rent, no sale proceeds, nothing coming in. But the loan payment is still due every month regardless. An interest reserve is the mechanism that solves that specific mismatch, and understanding how it's structured before closing changes how much cash you actually need to bring to the table.
What an Interest Reserve Is
An interest reserve is a portion of your loan proceeds set aside at closing specifically to make the loan's monthly interest payments during the rehab and holding period. Instead of writing a check out of pocket every month while the property sits non-income-producing, the lender automatically drafts the payment from funds already held back in reserve. It's built into the loan from day one, not something you request after the fact.
Interest Reserve ≈ Loan Amount × Interest Rate ÷ 12 × Number of Months Held
How It's Funded and Disbursed
The reserve is held back by the lender at closing — it's not cash that gets disbursed to you or your contractor. Each month, the lender draws the payment automatically from the reserve rather than debiting your bank account. It's important to understand that the reserve is still part of the loan you're borrowing: you're financing your own interest payments, which increases the total amount borrowed and the total interest cost over the life of the loan, in exchange for not having to fund those payments out of pocket while the property isn't producing income.
A Worked Example
Say you're financing $260,000 at 10.5% interest-only, on a projected 9-month hold.
| Monthly interest payment | $260,000 × 10.5% ÷ 12 ≈ $2,275 |
|---|---|
| Reserve held for 9 months | $2,275 × 9 ≈ $20,475 |
| Net effect | That $20,475 is deducted from your net proceeds at closing, then drawn down automatically to make each monthly payment |
When an Interest Reserve Makes Sense — and When It Doesn't
- Makes sense for a full gut renovation with an extended timeline and no rental income during the hold
- Makes sense if you'd rather preserve cash on hand for rehab overages and contingencies than make monthly payments out of pocket
- Less useful for a short, cosmetic-only flip where the hold period — and therefore the carrying cost — is minimal to begin with
- Less useful for a well-capitalized borrower who'd prefer to lower the total amount financed and reduce total interest cost by making payments directly
- Worth comparing both structures with your loan officer before you decide, since the right answer depends on your cash position and your project timeline
The Bottom Line
An interest reserve trades a larger financed loan amount for cash flow relief during the months your project isn't generating income. Neither approach is universally better — but you should know which one your term sheet is built around before closing, not discover it when the first draw request comes through.