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Get to know your options for ADU financing

Whether you are starting your ADU project soon or have plans for later, understanding how to pay for your ADU is a critical first step. ADU financing can be more complicated than a traditional mortgage but don't fret, you have plenty of options. The good news is that we’ve done the hard work to make it as easy as possible to get financing for your new ADU.

Our job is to be the best ADU resource in the world so we'll be updating this page regularly to give you the most recent figures so you can accurately plan for you ADU project. Interest rates rise and fall and when it comes to financing, outdated information is useless when trying to make a decision.

We’ll be covering 3 of the top financial products: Cash-out refis, HELOCs, and Home Share Investments. This is not investment advice but an educational resource to help you understand everything, without spending months of your own trying to get answers.

TLDR on ADU financing

  • Unlike a mortgage, there are many financing products for ADUs.
  • Renovation loans are a great option for ADU financing.
  • Most loans require that you have some home equity (this is the difference between how much you owe and how much your house is worth).
  • To know if you have enough equity, you need more equity than the cost of the ADU (~25% more).
  • Borrowers with low home equity and low credit scores (500+) can get qualified with a new form of financing where you pay no interest and share in the future value of your home.

ADU loans based on Home Equity

What is home equity?

Home equity loans are built around the the amount of ownership you have in your home. You have home equity when your home’s value (check Zillow) is greater than the amount you owe.

There are multiple ways you can get home equity. First, when you buy a home, you pay a down payment. This initial down payment is the amount you have in home equity. Typically it's around 5-20%.

Another way to gain home equity is through home appreciation. Given that your home increases in value, which is called appreciation, you will own that amount as your home equity.

Home equity increases or decreases based on market demand. If you live in an area where supply is low but demand is high, you'll likely find your home equity increasing. Appreciation is like a savings account with untapped cash storing up automatically. You unlock that cash through a lender that will help you take out that value in exchange for debt. In exchange for taking that cash out, you take on more debt than you had before. In other words, you trade debt to get cash.

Here’s an example of home equity:

If you paid a 5% down payment, you have 5% in home equity.

If your home grows 20% in 5 years, you would have 25% in overall home equity (20% appreciation and 5% in down payment).

Cash-out Refinance

Cash-out refinancing is a way to leverage the home equity that you’ve built up and get cash for it. For example, if you bought your house for $400k and it’s now worth $600k, you have $200k of home equity. Out of that $200k, you can take out 80-90%, which is $160k - $180k.

You can use that cash for whatever you’d like. Homeowners love to use cash-out refis to pay off debt but many homeowners use the cash for remodeling a kitchen, bathroom, or adding a guest house.

Cash-out refinance is referred to as “refinance” because you change your mortgage and get a new one. Basically one lender buys out your existing lender (sometimes they are the same lender). The interest rate will most likely be different so take that into account. When you do a cash-out refinance, you have a lender providing a new mortgage with higher debt in exchange for cash that you can use for construction.

Who should use a cash-out refinance for an ADU?

  • If your home equity is 25% more than the cost of the ADU (eg if the ADU is $100k, you should have at least $125k in equity).
  • If you have good credit. This will get the lowest interest rates.
  • If your current interest rate is high and the market interest rate is lower.
  • If you want to shop a wide variety of lenders (they are everywhere).

Who shouldn’t use a cash-out refinance for an ADU?

  • If you don’t have enough home equity or you are saving your home equity for another life need.
  • If you recently did a cash-out refinance and don't have enough home equity.
  • If the market interest rate is higher than what you are paying and you don't want a higher rate. If interest rates increases (like what is happening in 2022), you could be paying a higher rate.

Home Equity Line of Credit (HELOC)

A home equity line of credit (HELOC) is a type of second mortgage, which you hold alongside your primary mortgage. It’s similar to a cash-out refinance where you can pull out a portion of the home equity that you have in the home and use the cash for any purpose. The major difference is that HELOCs are a second mortgage and they typically have variable interest rates. This means the rate would go up (or down) during the payback period of the loan.

The structure of a HELOC is like every credit instrument where there’s a “line” of capital that you can pull from. It’s designed so that you only pay interest on the capital you take out, until a certain date that is predetermined.

How HELOCs work is they let you borrow cash in "draws". This works well for construction projects because you will pay contractors when they hit certain milestones. The “draw periods” are typically 5-10 years and during those periods, you typically only pay interest. After 10 years, you pay the loan back with both interest and principal payments.

It’s important to note that most HELOCs have a variable interest rate which means the rate can go up or down depending on what the market is doing. This could leave people with monthly payments that are unfeasible. However, there are a growing number of lenders that offer fixed rate HELOCs so be sure to investigate both options.

Who should use a HELOC refinance for an ADU?

  • If you are needing to get the funds ASAP, HELOCs are typically quicker to close.
  • If you want to keep your current mortgage and not refinance it.

Who shouldn’t use a cash-out refinance for an ADU?

  • If you might worry about variable interest rates taking you higher than you could pay.
  • Monthly payments will increase if interest rates rise.
  • If you don’t have enough equity built up in your home to cover the high costs of construction.

ADU Equity Share Investments

Many homeowners can’t get qualified for home equity loans, or more importantly, they are able to add more debt to their monthly expenses. That’s where alternative financing shines. Instead of a monthly payment, you share in the future appreciation of your house.

For homeowners that can’t get an ADU loan, there’s a new financing option called Home Share Investments (HSI). HSI is an investment, not a loan, where you receive the funds to cover an ADU without having to pay any monthly payments. In exchange, the investor gets a small share of the future appreciation of their home. Imagine having an ADU that generates $1k-$8k per month, without having to pay any monthly payments.

This investment is similar to a startup company getting an investment from a startup investor. In a startup, an investor offers capital to a team, in exchange for a share in their company. The investor is betting on the company growing.

Since these are investments on a speculation of your properties future value, they aren’t based on traditional requirements like credit score, debt-to-income ratios, and LTV. This means almost anyone can get qualified if you own a home.

Who should use a Home Share Investment for an ADU?

  • If you don’t want to pay monthly payments.
  • If your ADU costs too much for a conventional loan.
  • If you can’t get qualified from a lender because of credit, income, or home equity.

Who shouldn’t use a Home Share Investment for an ADU?

  • If your ADU costs more than half of your home.
  • If you need all the future appreciation that your home will generate.
  • If you want to pay less than the total interest of what you would pay on a traditional loan.

Calculate and map out different scenarios with our ADU Equity Share calculator.

How much does an ADU cost?

You might find that contractors or homebuilders are shy about giving you a price. They often will list their “base price” which doesn’t include site costs, permitting, scope buffers, and upgrades. Modular and prefab homebuilders have the ability to give you a more precise cost but they cannot give you shipping or site costs until a site analysis is completed. This analysis is step 1 for almost every homebuilder. You most likely will need some savings to cover this cost. Note that you will want some savings to also cover design. Homebuilders that have designs can include those in their prices. But if you want something custom that fits your backyard, you’ll want to hire a designer or architect.

If you live in California, you can take advantage of a new $40,000 CalHFA grant to homeowners building an ADU.

How to get started with financing an ADU

Before you get quotes from a lender for financing, start by getting an “all-in” estimate of how much your ADU will cost. This can be provided by your contractor or homebuilder and should include design, engineering, site work, labor, materials, permits, and more. Take that all-in number to multiple lenders and shop around for the best rates.

Alternatively, you could get a financing quote for the max amount. Then you could shop different homebuilders to fall within that budget.

How to find lenders to finance an ADU

  • Local banks and credit unions
  • Mortgage broker
  • Online lender (Dwellito can help)

A great place to start is with your local bank or credit union. They have incentive to support the local community and finance local projects. If they don’t have the right options, know that you always have other options. Financing is an incredibly large part of the economy with many lenders and brokers.

If you have any questions or if we can help at all, reach out and let us know how we can help!

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Learn more about Home Share Financing and Interest Based Financing. Use our Home Equity Investment Calculator to get an estimate for your ADU financing.