Interest reserve account: Overview, definition, and example
What is an interest reserve account?
An interest reserve account is a special account set up by a borrower and lender to set aside funds specifically for the purpose of paying interest on a loan during a predetermined period. This account is often used in situations where the borrower may not have the cash flow to make interest payments during the early stages of a project or loan term. The funds in the interest reserve account are drawn upon as needed to cover interest payments, ensuring that the borrower does not fall behind on payments while they focus on generating income or completing a project.
Why is an interest reserve account important?
An interest reserve account is important because it provides financial relief to borrowers who may have difficulty making interest payments during the early stages of a loan, such as in construction projects or business startups. It ensures that the borrower does not default on the loan due to temporary cash flow issues, providing both the borrower and the lender with security and peace of mind. For lenders, the interest reserve account helps reduce the risk of missed payments or loan defaults, while for borrowers, it allows them to focus on business growth or project completion without the immediate pressure of paying interest out-of-pocket.
Understanding interest reserve account through an example
Let’s say a company is taking out a loan to finance the construction of a new building. During the construction phase, the company does not yet have significant revenue coming in and may not be able to make regular interest payments. To help with this, the lender and borrower agree to set up an interest reserve account. The borrower deposits a portion of the loan into this account, and the funds are used to pay the interest during the construction period. This allows the company to focus on completing the building while ensuring that the loan remains in good standing.
In another example, a startup business secures a loan to fund its operations. The business is still in the early stages and has limited income. To help manage this, the lender and borrower agree to create an interest reserve account to cover interest payments for the first year of the loan. This allows the business to use its cash flow for operations while the interest is paid from the reserve account.
Example of an interest reserve account clause
Here’s an example of how an interest reserve account clause might appear in a loan agreement:
“The Borrower agrees to establish an interest reserve account, funded with a portion of the loan amount, to cover interest payments for the first [Insert period, e.g., 12 months] of the loan term. The funds in the interest reserve account shall be used solely for the purpose of paying interest on the loan, and any remaining balance in the account shall be applied to the principal balance of the loan upon the conclusion of the reserve period.”
Conclusion
An interest reserve account is a valuable tool for borrowers who need financial flexibility during the early stages of a loan or project. It ensures that interest payments are covered while the borrower focuses on generating income or completing their project. For lenders, it provides security that the loan will remain current and avoids the risk of missed payments. By understanding the role and structure of an interest reserve account, both parties can ensure smooth and manageable repayment terms, reducing the likelihood of default and maintaining a healthy borrower-lender relationship.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.