ADU Financing Options to Avoid

Introduction

Plenty of homeowners want to build an accessory dwelling unit on their property, but many lack the cash necessary to complete the project. Garage conversion ADUs usually start at around $150k, while a ground-up new construction often costs $200k-500k. With a price tag that high, it’s no surprise that many property owners need outside financing in order to pay for an ADU construction.

Thankfully, there are many reliable and fiscally responsible options for financing an ADU construction or conversion, which you can read about in our guide “How to Finance an ADU or Garage Conversion.” Our sister company Homestead has a great post on how to fund SB 9 projects, which can include ADUs, JADUs, and duplexes.

There are other financing options, however, that you'd be better off avoiding. In the following guide, we’ll examine some of the popular but less-than-ideal avenues for funding an ADU project and suggest safer alternatives. We’ve broken them into two categories: options to avoid at all costs, and riskier choices.

Options to Avoid

We’ll begin with the options that should never be used under any circumstances. These include PACE loans and credit cards.

PACE Loans

Property Assessed Clean Energy (PACE) programs are designed to help homeowners finance clean and renewable energy projects. PACE “loans” aren’t technically loans, but rather tax assessments. Unlike traditional loans, the assessment is attached to the property itself rather than the borrower.

There is very little regulation over PACE programs and private companies often profit off of them. Some contractors try to sell homeowners on PACE assessments, but beware: these risky, quickly approved financing methods have very high interest rates and can sometimes lead to home foreclosure. And if that’s not enough to convince you to stay away, PACE programs are actually illegal to use for building ADUs.

Credit Cards

Credit card offers try to entice homeowners with promises of high rewards and low introductory rates, but never use a credit card to fully finance an ADU construction. Credit cards are unsecured and often come with high interest rates, which means your ADU construction will turn out to be much more expensive than it would first appear.

And while they're not dependent on home equity, unsecured personal loans and credit cards do require a substantial household income and a good credit score for approval.

Risky Options

The following method aren’t the worst choices for funding an ADU construction, but they’re certainly not ideal. Proceed with caution!

Personal Loans

Many homeowners with lower home equity choose to take out personal bank loans to pay for ADU construction, simply because they are uninformed about other options.

How it works

Most banks allow offer personal loans of up to $100k, and some offer incentives for existing customers. Be aware that most lenders will only approve applicants with a high credit score and low (<40%) debt-to-income ratio. If you’re considering a personal loan to pay for an accessory dwelling unit, make sure you shop around for the best terms and interest rates before committing.

Pros:

• Not dependent upon established equity

Cons:

• Higher closing costs and interest rates than refi loans
• Must have low DTI and high credit to qualify

Summary:

Personal loans can be a reasonable short term solution for homeowners with no or low home equity, provided you follow quickly with a refinance or home equity line of credit (HELOC). Even if you do qualify, higher interest rates mean you’ll end up spending way more in the long run.

Alternative:

• If you have some equity in your home, choose a cash-out refinance or renovation loan
• If your home equity is low, a home equity investment (HEI) might be a better choice

Construction Loans

Construction loans are short-term loans strictly for construction and home improvement projects.

How it works

Construction loans allow homeowners to borrow based on the projected value of their home, post-renovations. Unlike renovation loans, which are usually delivered in the form of a lump sum upfront, construction loans dole out specific amounts of money at fixed points in the building process.

While construction loans can increase the borrowing power for homeowners with less equity to borrow against, they also have higher closing costs based on the new property value. They’re more complicated, too: in the interest of lender protection, construction loans require a draw schedule, numerous inspections, and frequent updates on construction progress.

Pros:

• Not dependent upon established equity
• Higher borrowing power than traditional refinance loans

Cons:

• Construction must be completed within limited timeframe
• Loan must be repaid or refinanced within 2 years or less
• Require extra restrictions and bank oversight
• Higher closing costs and interest rates than refi loans
• Funds aren't fully accessible upfront, as money is portioned out and released only at certain milestones in the building process
• Must have low DTI and high credit to qualify

Summary:

While construction loans can be a reasonable option for certain home improvement projects (like SB 9 lot-split developments), they're not the best fit for building a backyard cottage or granny flat. We only recommend construction loans for qualifying homeowners with low home equity who are building a ground-up construction and are able to refinance immediately upon completion of the project.

Conclusion

Now that you know which ADU financing methods to avoid and why, we suggest you read up on the best methods for funding an ADU. If you still have questions, contact Otto ADU. Our ADU experts can help you figure out the best financing options for your project.