How a Construction Loan Actually Works
A construction loan is funded in draws, not as a lump sum. As the project incurs hard and soft costs, the borrower submits draw packages and the lender funds against verified progress. Interest accrues only on the drawn balance — not the full commitment — which is why average outstanding balance is the central modeling variable.
The Interest Reserve
Because the project isn't generating cash flow during construction, the lender requires an interest reserve — pre-funded from the loan itself — to service interest during the construction period. The reserve sizing math is straightforward: Average Outstanding × Rate × Period.
Average outstanding is typically 50–60% of the full commitment for ground-up construction (because draws ramp slowly) and 65–75% for value-add renovations (because draws hit faster).
The Net Usable Loan Reality
Headline loan commitment minus interest reserve minus origination fees minus closing costs = net usable loan. On a $15MM commitment, the net usable can easily be $13.5MM. Sponsors who don't model this correctly find themselves capital-short halfway through construction.
Pair this with the LTC Calculator, the Sources & Uses, and the Yield-on-Cost for the full construction underwriting package.