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An interest reserve is a portion of a loan — common in private and construction lending — that the lender holds back at closing and uses to make the borrower’s interest-only payments directly, instead of relying on the borrower to pay from their own cash flow.
On short-term or bridge deals, a private lender often can't be sure the borrower's cash flow will reliably cover monthly interest — a pending sale hasn't closed yet, a renovation isn't generating income yet, or the borrower's income is genuinely irregular. Reserving several months of interest out of the loan advance removes that risk for the lender.
The trade-off is that the reserve is deducted from the funds actually put in the borrower's hands, even though interest accrues on the full loan amount, including the reserve itself. Once the reserve runs out, the borrower has to start making payments directly or have an exit strategy ready before then.
Common in private lending: interest reserves are a standard structuring feature of private and alternative mortgages in Canada, disclosed as part of the loan terms.
Net advance is lower: the reserve reduces the funds actually advanced to the borrower, even though the full loan amount accrues interest from day one.
Runs out eventually: once the reserve is depleted, the borrower must resume making interest payments directly or refinance/exit before that point.
Disclosed up front: provincial regulators expect the size of the reserve and how it's calculated to be disclosed clearly to the borrower before they commit to the loan.
A private lender approves a $250,000, 12-month interest-only bridge loan and structures a 6-month interest reserve:
$250,000 − $15,000 = $235,000. The lender draws the borrower's own $2,500 monthly interest payment out of the $15,000 reserve for the first six months, so the borrower makes no out-of-pocket interest payments until the reserve is used up.
Definitions reflect Canadian federal and provincial rules as of the “Updated” date above. Not advice for any specific file.
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