April 29, 2024
With recent legal and market changes ADU’s are on a lot of homeowners minds as a potential way to make extra rental income or provide housing for family members that otherwise could not afford to live nearby due to rising rental costs. An ADU can have huge positive impact on your family’s personal finances but can be surprisingly difficult to figure out the best way to finance.
As federal and local governments are increasingly encouraging the development of ADUs Lenders are warming up to the idea and are getting creative with ADU financing.
Lenders typically expect ADU to have all the basics such as a separate entrance, full kitchen, bathroom and a place to sleep (aka studio ADU are valid). ADUs must be typically be smaller than the primary home - minimum and maximums square feet depend on your state and country laws and they also usually stipulate expectations regarding utility hookup and placement.
Within that basic definition home owners have a number of options that will affect the cost of the loan. Typical options include Garage / basement renovations, placing a prefabricated adu on the property, or building from scratch.
I wish I could tell you there was one best way to finance a ADU project but current and future homeowners looking to finance an Accessory Dwelling Unit (ADU) build have several options, which you choose depends on a couple factors unique to you and your situation.
These include utilizing home equity loans, HELOCs, home improvement loans, personal loans, and in rare cases construction loans. These financing avenues provide you flexibility in funding, allowing you to tailor financing to your specific needs. Choosing the wrong financing option on the other hand could host you tens of thousands of dollars so its a super important decission.
HELOC
Home Equity Loan
Home Improvement Loan
Construction Loan
Unsecured Personal Loan
Using a Home Equity Line of Credit (HELOC) to finance an ADU build can offer several advantages. HELOCs enable homeowners to tap into the equity you have built up in your property, often at lower interest rates compared to other forms of borrowing, thus potentially reducing overall borrowing costs. HELOCs also provide flexibility in accessing funds, enabling homeowners to draw funds as needed during different stages of the ADU construction process, effectively managing cash flow. Lastly, HELOC interest payments may be tax-deductible, providing additional financial benefits. Overall, using a HELOC to finance an ADU build can offer convenience, cost-effectiveness, and tax advantages.
Home Equity Loans are quite similar to HELOCs but provide a fixed amount of money backed by your equity as a homeowner. Prior to completing renovations, homeowners need to obtain a second appraisal of their home. This mortgage, which counts as a second mortgage, has a fixed rate, typically higher than your first mortgage.
Home Improvement Loans, also known as Renovation Loans, include FHA 203(k) Rehab loans and Fannie Mae Homestyle Renovation loans. FHA 203(k) rehab loans are ideal when you are planning to update a property with an existing house and would like to add an ADU to the property right away where you will occupy full time for at least 1 calendar year prior to selling.
Fannie Mae Homestyle loans are quite similar but also enable you to finance the remodel of a vacation or rental property. They are financed in 15 and 30 year terms which is ideal if you would like to use/ own the property for a long time.
Homebuyers originally used construction loans for purchasing land and building a new house and ADU simultaneously. Projects like this are funded slowly over several months with dozens of small payouts. These loans are less popular today due to the extensive paperwork associated with them, and many contractors and builders are unwilling to work on ADU projects financed by construction loans. We don’t frequently recommend them.
Personal Loans are typically higher interest than other options on this list, but they can be a savvy move if you are a homeowner with limited home equity or if the ADU you are building is less expensive and partially self-funded. This type of loan can also be a possibility if you plan to build an ADU that is not on your own property.
Figuring out how to finance a ADU can be stressful and complicated but it doesn’t have to be if you know the right questions to ask. Determining the best financing option for you and your family depends on:
Whether you have already purchased a property and if you have significant equity built up.
What your current interest rate on your home loan is
Whats your current credit score
How much the gap is between your projected costs and the cash you have on hand.
Market conditions and local lender policies