A Great New Option for Financing Your Accessory Dwelling Unit
Updated: Sep 30, 2022
An accessory dwelling unit, often abbreviated as ADU, can be a great way to increase the market value of your property, add some extra space, and generate additional cash flow or side income through rent. So it's no surprise that ADUs have grown in popularity in many parts of the country.
If you're planning to build an ADU on your property for some extra living space or simply want an additional source of income, then you're in for a treat. This article will help you understand what an ADU is, what benefits it can offer, and most importantly, how to get the financing you need to construct an ADU on your property.
What is an ADU, and why would you consider building one?
An accessory dwelling unit (or ADU) is a separate, independent house or studio that is located on the same plot of land as a larger, single-family home. There are two ADUs that can be attached to or detached from the primary residence.
Usually, ADUs are akin to those tiny houses you see on Youtube. They have their kitchen, bathroom, and living area. For privacy purposes, they (should) also have an entrance separate from that of the main house to maximize privacy and convenience.
You may build an additional dwelling unit for extra work and recreation space. Many people build ADUs on their property to provide a separate living space for an elderly parent or an adult child living at home. That's why ADUs are also sometimes known as granny flats.
If you don't use it, an ADU can also be rented out to a tenant for some extra monthly income. Lastly, an ADU will increase the resale value of your home by a significant margin, usually giving you a pretty good return on investment.
ADU Cost And The Possible Need for Finance
We have written about how much it would cost to convert your garage into an ADU in a separate blog. It would cost you somewhere between $80,000 to $170,000, more or less. We understand that this is a lot of money, so we also included some financing options in this article to help you out.
1. Home equity line of credit (HELOC)
A HELOC is like having a credit card secured by your home's equity. Many homeowners like HELOCs because it only requires them to pay interest on the actual amounts withdrawn. HELOCs often come with a variable interest rate. Sometimes, there's even a low introductory rate for a year or so. You may decide to take advantage of the introductory rate and then pay off the balance by refinancing your mortgage when the ADU is built.
Your annual income and credit score may affect these terms. For example, well-qualified borrowers may have greater access to high loan-to-value (LTV) HELOCs. The higher the LTV, the higher the interest rate. Therefore, you should only borrow as much as you realistically need.
2. Cash-out refinance
Instead of a home equity credit line (HELOC), you might consider an outright mortgage loan or also known as a second mortgage.
Do you have equity in your home? If so, consider a cash-out refinance. Depending on your income and credit, you can often borrow up to 80 percent or more of your property's value. You simply borrow more than you currently owe and take out the difference in cash. You then use that money to pay for the ADU. Low mortgage interest rates make this an attractive option for many.
With rising real estate values, homeowners often have more home equity than they realize. Consider a homeowner with a mortgage balance of $100k on a property worth $250k. Borrow 80 percent ($200k), and take $100k out to pay for the ADU. Your completed ADU will increase your property's value, and your equity will continue to go back up over time.
3. ADU construction loan
An ADU loan is one of the new financing options available to help finance your ADU dreams. It is a temporary, short-term loan, and some call it a construction loan.
It is often an interest-only loan with a maximum term of 12 months. In effect, the lender advances funds based on the ADU's expected contribution to the property's overall value. A rental ADU may increase a property's value by approximately 200 times the monthly rent. For example, if the rent is $1,800 per month, the ADU may increase the property's value by up to $360,000.
To qualify for a construction loan for an ADU, you will need to hire a professional appraiser who must review the architectural plans. The appraiser determines what the ADU will be worth when it's complete. The more comparable ADU properties are in your area, the more the appraiser will have the information needed to submit a thorough appraisal to the lender.
Such a loan for an ADU usually assumes two things. First, that construction concludes in a timely way. Second, the homeowner will pay off the ADU loan with a new mortgage on the entire property. One drawback is the cost of an ADU construction loan, as interest rates and closing costs are typically higher than a traditional mortgage.
4. Financing from the Housing and Community Development (HCD)
In line with the state’s push towards creating more rental opportunities for very-low to moderate-income households, the state now requires that cities and counties develop a plan that incentivizes and promotes the creation of ADUs that can be offered at affordable cost.
As such, the HCD has developed a list of existing state grants and financial incentives in connection with the expenses for the planning, construction, and operation of an ADU with affordable rent for very-low to moderate-income households.
Here are some of the potential State Grants and Financial Incentives for ADUs:
CalHome Program — State funds to local public agencies and nonprofit corporations for first-time homebuyer mortgage assistance, including a home purchase with an ADU or JADU; owner-occupied rehabilitation assistance including rehabilitation of ADUs or JADUs; ADU/JADU assistance including construction, repair, and reconstruction; and homeownership development project loans including predevelopment and carrying costs during construction related to ADUs and JADUs (HCD CalHome program).
Local Early Action Planning (LEAP) Grants — State grants to local jurisdictions, including eligible partnerships for housing planning and developing or improving an ADU ordinance in compliance with Section 65852.2 of the Government Code (HCD LEAP program).
Local Housing Trust Fund (LHTF) Program — Matching funds to local and regional housing trust funds. Funds may also be used for the construction, conversion, repair, reconstruction, or rehabilitation of ADUs or JADUs (HCD LHTF program).
As we see the rise in the popularity of ADUs as a viable residential option, we also see a rise in the number of financing options available for homeowners. The state, at least here in California, practically encourages homeowners to build ADUs. This is probably the perfect time for you to consider converting your otherwise idle garage or backyard into something productive as an ADU.
Looking forward to building your ADU project, but you’re unsure if you have enough money to build one? Book an appointment today with one of our ADU specialists, who will help determine if ADU is a good fit for you and find the best and most creative financing to bring your ADU to life.