How to finance an ADU is an opening statement. Many homeowners are starting to learn about the benefits of creating an accessory dwelling unit (ADU), also known as a granny flat or in-law suite, guest house or carriage house. Family members share land, but not the roof. Younger family members get an opportunity to have affordable housing wight in the backyard of their family’ primary home.
The simple math of small homes dictates that you should build as big as possible. Bigger square footage allows to spread utility connection costs and lowers the construction cost per square foot.
The question is, “How much ADU can one afford?” Remember to consider monthly payments and rental income if you plan to rent the ADU out. Make sure the lender is taking into account the future value of your home, after the construction is complete.
One of the biggest challenges is paying for the unit’s design, building permit, and construction. Only a few have this much cash available.
As the labor and building material costs are high, financing the projects is double challenging. High interest rates do not help.
Homeowners have many options as to how to finance the ADUs. Most use a mix of financing: savings, HELOC or RE-Fi, and credit cards.
To learn what will work best, let us start with the three cornerstones of the financing world: Equity, Income, and Credit.
Knowing where you stand regarding this financing trio will help determine the best option for you.
You may be surprised that most homeowners use several financing options to finance their backyard projects. Let us figure out which is the best ADU financing options for you.
One of the most critical components of the financing puzzle is having equity in one’s home. Equity is the difference between the value of the property minus any loans or liens against the property. If you sell the house, the selling price minus what you owe to the bank for the mortgage would be your equity.
A homeowner with higher equity can get a cash-out refinance or a line of credit to finance their backyard cottages. With enough equity, you can apply for a new mortgage to replace your existing mortgage. You can also add a new mortgage on top of your current mortgage. This lets you keep your existing mortgage rates if your primary mortgage is lower than those currently offered. The fees, in this case, may be lower than for refinance.
A home equity loan is a one lump sum payment, while a HELOC typically comes with variable interest rates.
A Home Equity Line of Credit, or HELOC, is another option someone with a higher equity in a house could pursue. You are borrowing against your home equity on your schedule. You start paying interest once you tap your HELOC – you can imagine that solid financial discipline is necessary.
Pay close attention to a HELOC’s floor rate. The “floor” is the lowest interest rate a lender will charge for that loan. Be sure to check that and ask about it when you apply. If you have a floor, your rate will not go below that interest rate floor, whatever it is in your loan documents.
Another variable in the financing equation is income. The bank’s loan manager would look at the family (or household) income to repay the debt. Even with low equity, higher-income homeowners may get a construction loan to help finance their accessory dwelling units.
A construction loan has higher interest rates and often puts a time limit on your project. This loan rarely works for interior conversions but is appropriate for newly constructed ADUs. Some banks take into account the future value of ADU. Still, most will release funds once work is completed on schedule as an extra safety measure. You may hear the term “construction-to-permanent loan”. This type of loan assumes that you will re-finance once construction is over.
Renovation loans that provide money specifically for repairs and upgrades have high Loan-to-value ratios, often above 95%. However, these loans are capped, and that number varies by the County. Expect to see the time limit on your project and more paperwork than with other loans.
There are three types of renovation loans: FHA203k, Choice Renovation Loan and Homestyle. FHA stands for Federal Housing Administration.
Your lender will process standard FHA 203k loans on a draw basis – similar to construction loans. If you need less than $35,000 to convert your existing space to a junior accessory dwelling unit, a limited FHA203k loan will let you draw up to 50% for materials, with the remainder drawn on completion. Owner occupancy is a requirement. No luxury items are allowed.
The Homestyle loan does not require owner occupancy, so an investor can use it to purchase or refinance. However, the down payment for investors will be 15%, with 5% for a regular homeowner. All renovation work must add value to the property. Your lender will let you draw up to 50% for building materials, with the remainder drawn after inspections by the appraiser. The beauty of the Homestyle loan is that it allows up to 75% of the property value after improvement.
Choice Renovation Loan actually is for building an ADU – ask your lender about it!
When considering a renovation or construction loan, please determine long-term financial needs and ensure you have sufficient funds. Be careful not to overbuild for your area. You want to avoid being in a situation where your property is the most expensive in your neighborhood.
Are there any options for homeowners on the lower income spectrum? Do not default to personal loans. A few options are available, starting with a Home Ready Fannie Mae Loan, 401(k) loan, local Credit Union Second Loans, and Reverse Mortgage.
Do not discard local credit unions. For example, the Redwood Credit Union offers loans up to $500,000 with up to 85% combined Loan to Value (including loans for primary, secondary, and investor properties).
Talk to a professional mortgage broker and ask about other available loans that may work for you:
Financing for ADUs is a hot topic, and new ways to finance the backyard construction project may exist in your area. Check local grants, and talk to the non-profits in your city.
There are also several startups offering new financing ideas. You may see the terms equity-share, profit-share, or rent-share. These options may be available to homeowners who do not qualify for other, more traditional loans. However, the final payout price, equal to the cost to the homeowner, may depend on the home’s future value. In exchange for upfront funding, your loan provider will share in the future home value. Some startups are experimenting with ground lease agreements. Most of these new financing options are not regulated, which means they carry a risk for you as a homeowner.
Please do your homework and consult a financial adviser with fiduciary responsibilities to confirm you are getting a good deal.
Let us look at the Credit, the latest piece of a puzzle.
The better your credit rating, the better the financing terms you qualify for. A higher credit score will mean you will be eligible for contractor financing, home improvement credit cards, and regular credit cards.
You may have lower credit scores.
If you have recently started your credit history – and in banks’ terms, ten years is recent – this will play against you. Some events that impacted your credit history may mean you will be considered a credit risk and need to apply for private loans. Unless you have friends and family who can give you a personal loan or you have retirement funds you can tap into.
Meet an experienced mortgage broker who has done hundreds of loans across California from her base in SoCal
You may need a mortgage officer who understands real estate as a lender and prefab construction as a builder.
In summary, there are many different ways to finance your ADU. However, it is essential to reach out to a trusted financial advisor who has been involved in the ADU space for some time and knows its particular programs.
They will be discussing the following numbers with you:
Estimated FICO score, remaining balance amount of mortgage, details on second mortgage, HELOAN or HELOC (if applicable) and, of course, the loan amount you want to take out.
That said, asking the right questions about various options is also essential. Do not forget to ask your own questions!
What is the maximum Loan to Value Ratio allowed?
What documents are required for pre-approval?
What is the amortization period for your loans? How many years will I have to pay it off?
What will happen if I miss a monthly payment?
Do you require a credit report not older than three months?
How much will it cost a homeowner to borrow/receive $100 K?
What is my approximate monthly payment?
Is property appraisal needed?
Do you have an application fee, and how much? What are the processing fees?
Does the contractor need to be approved by you?
How long is the construction period? Is there a maximum?
Will there be construction draws?
Do you allow owner-builders?
Do you have a limitation on who a property owner rents the ADU to?
Do you have any income requirements for the prospective tenants?
Do you allow future income from ADU to qualify for the financing?
Employment information, property information (including home insurance), financial profile (including current income and savings and investment balances), credit check, home appraisal, and title report are the typical documents required for loan approval.
As an ADU professional, I would like to ensure that you get the absolute best source of financing to develop your project and that it will be a win-win for all parties concerned.