Construction Budgets: Contingency and Interest Reserve Explained

A construction lender reads your budget to answer one question: if everything goes roughly as planned, and a few things go wrong, will this project still finish? A fundable budget is complete, backed by bids, and has room built in for the unexpected.

This article walks through the parts of a budget a lender focuses on, how contingency and interest reserve work, and what happens when costs run over. The numbers below are for illustration only.

Hard costs and soft costs

Hard costs are the physical construction: site work, foundation, framing, roofing, mechanical systems, finishes and the contractor's fee. Soft costs are everything else needed to deliver the project: architecture and engineering, permits and fees, insurance, legal, inspections, and the cost of financing itself.

Common budget mistakes are leaving soft costs thin, forgetting utility connections or site-specific items, and carrying lump-sum lines with no breakdown. A lender seeing a vague line assumes the risk is higher than shown.

Contingency

Contingency is money set aside for costs you cannot yet identify. It is not a slush fund for upgrades and it is not an invitation to underbudget elsewhere. Lenders usually want to see one, and they scrutinize how much is carried relative to the project's risk. A rehab of an older building with hidden conditions generally calls for a heavier contingency than a straightforward new build on a prepared lot. We do not publish a required figure because it depends on the project, but the principle is to size it to the unknowns.

Interest reserve

During construction, the loan balance grows as draws are made, and interest accrues. An interest reserve is a line in the budget that pays that interest from loan proceeds, so you are not writing monthly checks from your own pocket while the building generates no income.

For illustration only, suppose a project is expected to take a number of months to build, with draws increasing the balance over that time. The reserve has to cover interest on a balance that rises, not on the full loan from day one. If the schedule slips, the reserve is consumed for longer, which is one reason delays are expensive and why we discuss draw timing separately.

A simple illustration

Suppose a budget shows $1,000,000 of hard costs and $200,000 of soft costs. Add a contingency line of, say, $80,000 and an interest reserve of $60,000, for a total budget of $1,340,000. The lender then considers how much of that total the loan will fund and how much you contribute. The ratio of loan to total cost is what loan-to-construction-cost explained covers. Our program goes up to 90% of construction cost, and the actual figure depends on the deal.

These figures are hypothetical and not a guide to what any project should carry.

When costs run over

Overruns happen. What matters is how they are handled. Typical lender expectations:

1. The budget stays in balance. If one line goes over, you show where the money comes from: contingency, savings elsewhere, or additional funds from you.
2. You report problems early rather than at the next draw.
3. Changes are documented and approved before the work is done.
4. You have the capacity to fund the gap. If the contingency is exhausted, the project may stall until you do.

This is why sponsor liquidity matters. A thin budget backed by a borrower with no reserves is a harder file than a conservative one.

Building a fundable budget

• Get written bids for major trades and attach them.
• Match budget lines to how the contractor will bill so draws line up.
• Include permits, fees, insurance, utilities and financing costs.
• Size contingency to the project, and be ready to explain it.
• Include an interest reserve and show the assumed schedule.
• Show your own equity or contribution clearly.

For the full picture of what we review, see ground-up construction financing in California. Details of our construction program, including loan amounts to $75 million and conversion to a permanent loan at conventional rates on completion, are on our construction page.

This article is general information only, not legal, tax or investment advice.

Have a budget you want a second set of eyes on? Call (800) 943-1314 or apply online.