From traditional mortgages to alternative funding, this list will help you find the right financing option for building your ADU.
Whether it is to provide housing for relatives, or rent out for passive income, more and more homeowners are drawn to the idea of building an ADU on their property.
ADU development does not only bring personal benefits for homeowners but also helps with fighting the housing crisis, especially in California.
“If just 10% of the city’s 500,000 single-family homes had an Accessory Dwelling Unit, Los Angeles could increase its housing density by half in just a handful of years. Most notably, this could be done without altering the character of a neighborhood.”
However, up until recently, many homeowners failed to turn this idea into reality due to the lack of ADU financing options.
Luckily, the increased demand for ADUs opened up many funding possibilities for homeowners.
And we are here to walk you through ADU financing to help you decide the best option for you.
Before we explore some of the available ADU financing options, let’s take a look at the costs of building an ADU.
According to a recent report from Terner Center for Housing Innovation, the median statewide construction cost for an ADU in California is $150,000 or $250/square foot.
However, there are notable price variations depending on the county, unit typology, and the number of bedrooms in the ADU.
For example, while garage conversions cost around $90,000, the estimated price for building a detached unit is $180,000.
And while studios are estimated at $100,000, ADUs with 2 bedrooms cost around $200,000.
ADU Loans and Financing Options
Many of the available ADU financing options are based on the amount of equity that you have on your primary home, your household income, and your credit score.
The issue with these traditional options is that there is often a gap between the cost of ADU construction and the homeowner’s borrowing power.
Luckily, some alternatives let you take out a loan based on the future value of your home. Such is the case with some renovation loans, such as the Fannie Mae Homestyle Renovation loan.
Before making this decision, consider the future use of your ADU.
For instance, renting out your ADU can help you pay out the ADU loan or generate a positive return.
Rental prices for a new ADU in California that houses a family of 2 range from $1900 to $2300 per month, according to Terner Center’s report.
With all of this in mind, let’s take a look at 7 financing options you should consider when building your ADU.
1 - Cash-out Refinancing
Cash-out refinancing allows you to turn your home equity into cash. You can do this by getting a new mortgage that’s larger than the amount owed on your existing one.
This will enable you to pay off your first mortgage and use the remaining amount for financing your ADU, meaning that you will consolidate your primary mortgage and ADU funding into a single loan.
With this in mind, cash-out refinancing is a good option if you have built-up equity in your home.
Given the average ADU costs, you’ll need to have around $200k built up in Home Equity.
However, keep in mind that:
- Most cash-out refinances will let you take out only 80-90% of your equity in cash;
- A cash-out refinancing loan requires you to change your primary mortgage interest rate (likely higher).
2 - Unsecured Loans
Unsecured loans, or Personal loans, are based on the borrower’s creditworthiness, rather than by any collateral such as property.
One of the benefits of taking out an unsecured loan to finance your ADU is that your assets are not at risk. Another plus is that the application process is much simpler.
However, since these loans are riskier for the lender, they usually have higher rates and payments and the amount you can borrow is smaller.
For example, LightStream offers tiny house financing and their loans range from $5000 to $100,000, with a minimum interest rate of 4,99%.
So if you’re aiming for a simpler ADU project, such as a garage conversion or a studio, an unsecured loan can be a good choice for you.
3 - Home Equity Loans and Lines of Credit (HELOCs)
Another way to use your home equity for financing your ADU is by taking out a second mortgage - either a one-time loan or a home equity line of credit (HELOC).
A home equity loan will secure you a lump sum that you’ll need to pay out in fixed installments.
HELOCs are a bit different. Similarly to credit cards, they allow you to borrow money as needed with a variable interest rate.
Unlike the cash-out refinance loan, home equity loans do not replace your current mortgage. This means that the terms and interest for the first mortgage will remain the same, which is why it is preferred by many homeowners.
In fact, according to Terner Center's report, 56% of homeowners who built an ADU in California used a Home Equity Loan/HELOC to finance their project.
4 - Construction or Renovation Loans
Construction and renovation loans are equity loans specifically meant for renovation projects.
The main benefit of these loans is that they allow you to borrow based on the future value of your home once the renovation project (in this case, the ADU construction) is completed.
For example, Renofi will allow you to borrow up to 125% of the current home value and up to 90% of the after renovation value.
In contrast, cash-out refinance loans will only allow you to borrow an amount based on the current value of your home.
Many homeowners also choose the Fannie Mae Homestyle renovation loan for their ADU projects because it can qualify them for large amounts.
This gives them more borrowing power to cover the $150-$200k cost for building an ADU.
However, there are downsides to these loans as well. Many homeowners find the administrative requirements complicated, leading to a longer closing time.
Another issue is that they have a high denial rate, as 45% of applicants are denied, compared to only 18.4% of cash-out refinance borrowers.
5 - ADU Home Equity Share Investments
A home equity share agreement is an alternative way to tap into your equity, without all the hassle of taking out a loan. The idea is that an investor can provide you with up to $500,000 that you can use on your ADU in exchange for a share of the future appreciation of your home.
So if you don’t qualify for any of the loans above or you simply don't want to add more monthly expenses, this might be the ADU financing option for you.
This financing option is based upon the hope that the value of any property is likely to go up in the future. So it does not rely on traditional requirements such as credit scores or DTIs.
Not sure whether this is the right option for you? You can use our ADU Equity Share calculator to map out different scenarios or see what some of the best home equity investment lenders are offering.
How to make the right decision
There is no universal solution when it comes to ADU financing and ADU loans. Before making your decision, evaluate your funds, home equity, and credit score and weigh that against your project budget.
In the meantime, Dwelitto is here to help you stay on track with the latest ADU opportunities.
So if you are still on the fence about these financing options, see whether you qualify for CalHFA’s ADU Grant Program which can add $40,000 to your ADU funding.