Best Ways to Finance an ADU or Garage Conversion

Introduction

Many homeowners dream of building an ADU on their property to provide housing for relatives or rent out for passive income. Unfortunately, that dream often hits a snag when it comes to funding. In fact, obtaining financing is often the single biggest obstacle that prospective ADU builders face, according to UC Berkeley’s Terner Center for Housing Innovation.

Legislative changes over the past few years simplified the ADU permitting process, but the construction process remains complex and expensive. Converting an existing structure can cost upwards of $150k, while a ground-up new construction can cost $200k or more. Until recently, it was nearly impossible to build a granny flat on your property without high amounts of available home equity, household income, savings, and/or an immaculate credit score.

Thankfully, as the popularity of accessory dwelling units has increased, so to have the options for funding their construction. This guide will walk you through financing possibilities and help you determine the best option for you and your project.

Financing Options

Unless you have lots of cash on hand, there are five main financing options for ADU construction: cash-out refinancing, renovation financing, home equity loans/lines of credit, and Home Equity Investments.

Cash-out Refinancing

A cash-out refinance works by refinancing your first mortgage to release some of the home equity you've built up, which you can then use to fund the construction of your ADU.

How it works

Unlike taking out a second mortgage, this option allows you to consolidate your ADU funding and your mortgage into a single loan.

Pros:

• All money available upfront thanks to lump sum payment
• Simplifies repayment by consolidating mortgage and ADU financing into a single loan
• Interest rates are often lower than other borrowing options (e.g. construction loans, credit cards, etc)

Cons:

• Closing costs are often higher when compared with other financing options
• Borrowing power is limited, as most cash-out refinances only let you borrow up to 80% of your current property value.
• Home equity must be high, and recent home buyers rarely have enough equity built up to fully fund ADU construction
• DTI (Debt-To-Income) ratio must be low in order to qualify

Summary:

A cash-out refinance is an ideal choice for homeowners who have high amounts of home equity and prefer the convenience of a consolidated monthly payment. However, if your equity is too low or your DTI too high, it might not be an option for you.

Renovation Financing

A renovation loan is a type of home equity loan, specifically for home renovation projects. Essentially, a renovation loan enables the borrower to take out a predetermined amount of money based on the equity of their home.

How it works

In contrast to a cash-out refinance, which is determined by the current value of your home, renovation loans allow you to borrow based on the future value of your home once the renovations are complete.

Pros:

• Borrowing power is higher than traditional home equity loans (borrow up to 90% of your post-renovation value)
• LTV (loan-to-value) is much higher than traditional refi or equity loans

Cons:

• Requires home equity (although not as much as a cash-out refinance or home equity loan)
• DTI (Debt-To-Income) ratio must be low in order to qualify

Summary:

Renovation loans are a great choice for most folks with existing income and home equity looking to build a backyard cottage, as they enable homeowners to credit the value of their future renovation towards the maximum amount they are allowed to borrow. However, renovation loans require a low DTI and sufficient home equity. If you're lacking either of those, you may need to choose another type of financing.

Home Equity Loans and Lines of Credit (HELOC)

Home equity loans and lines of credit let homeowners borrow a predetermined amount of money based on the equity of their home.

How it works

Home equity loans (also called a "second mortgage") allow homeowners to access a portion of the equity they've accrued in their home in the form of a lump sum. In most cases, the maximum amount is 80-85% of your home’s value, minus the outstanding first mortgage.

Home equity lines of credit (HELOC) operate on the same principle, but allow homeowners access to a revolving line of credit rather than a fixed lump sum.

Pros:

• Borrowing power is typically slightly higher than a cash-out refinance

Cons:

• Interest rates for a second mortgage are higher than those for a first mortgage
• Variable interest rates are common, which means they might increase over time

Summary:

Home equity loans and lines of credit can be a good option for people with high home equity but lower cash flow. If you haven’t paid off much of your mortgage yet, however, you probably won’t get enough to cover the full price of ADU construction, including closing costs and other fees.

Home Equity Investments

Home equity investments (HEIs) are another financing resource for ADU projects. Unlike most financing options, HEIs from companies like Point and Unison make it possible for homeowners to access their home's equity without taking on debt.

How it works

With an HEI, you get a lump sum—up to 25% of your home's equity—in return for a share in the future appreciation of your property value. Point's HEI option is attractive to many homeowners because there are no out-of-pocket costs and no monthly payments. Plus, they make ADU investments accessible to everyone with equity, regardless of income or credit score. And they move quickly: applications are approved in minutes and funded in just a couple of weeks.

Pros:

• Debt-free
• No monthly payments
• Approval not dependent upon income, DTI, or credit score
• Quick approval process makes funds available sooner

Cons:

• Remodeling plans (including ADU construction) must be approved by investor
• Investor appraisal is non-negotiable
• You'll need to pay off the investor within a set period (typically 10 to 30 years) via a refinance, buyout, or selling your home

Summary:

We think HEIs are a great alternative for homeowners who can't access large loans. However, we don't recommend HEIs for those who can obtain whole-home refinancing, home equity loans, HELOC, or Renofi loans.

ADU Assistance Programs

In addition to the financing options outlined above, there are some organizations and local governments that offer grants and special loans for ADU development. While they rarely offer enough funding to fully cover the cost of construction, these grants and loans can help make it more affordable for homeowners to build an additional dwelling unit on their property.

CalHFA ADU Grant Program

The California Housing Finance Agency offers a grant program to assist homeowners in building an ADU on their property. Qualifying homeowners can receive a grant of up to $40,000 to help pay for predevelopment costs associated with ADU construction.

How it works

First, applicants must apply for a construction or second position loan through a private loan officer approved and trained by CalHFA. Once predevelopment is underway, the lender submits the grant application on behalf of the homeowner, along with invoices for predevelopment costs. Once CalHFA approves the grant application, it wires the allocated funds to the loan account. This lowers the amount of ADU loan principal repaid by the homeowner.

There are some restrictions, however: the grant is only accessible for homeowners who do not exceed the income limits with properties located within a Qualified Census Tract.

Pros:

• Less money to repay
• Higher borrowing power than traditional refinance loans

Cons:

• Timelines are uncertain due to new process and communication between multiple parties
• Requires a high level of paperwork and oversight, but Otto can help!

Summary:

The CalHFA ADU Loan Program is a great option for qualifying homeowners who were already planning on taking out loans to fund their ADU construction. Read our blog post on the CalHFA Grant Program to learn more.

Local ADU Programs

Many cities have their own local ADU assistance programs, so it’s worth researching the options available in your area (try searching “[your city] ADU grants”). Some of these programs offer ADU grants and forgivable loans, while others provide traditional loans specifically for ADU construction.

It’s important to be aware of the limitations of use for your local program, as many of these assistance programs come with affordability requirements for the ADUs they fund. Like the CalHFA Grant program, these loans and grants may not provide enough money to fully fund an accessory dwelling unit construction. And because many of these ADU grant and loan programs are still in their pilot stages, they only accept only a few qualifying applicants each year.

Financing Options to Avoid

Despite the drawbacks associated with the above lending options, they are all legitimate borrowing methods well-suited to financing an ADU construction. There are a whole host of other avenues, however, ranging from less-than-ideal to downright predatory. For more information, read our article on ADU financing options to avoid.

How to decide

Since there’s no one-size-fits-all solution to ADU financing, you’ll have to evaluate your available funds, established home equity, and credit score, and weigh that against your project budget to decide which option is the right fit for you.

That might seem like a daunting task, but you don’t have to do it alone. Otto ADU can help you determine the ideal financing choice for your specific needs — simply fill out this form and one of our ADU experts will call you to talk through the best options.