It is important to appropriately and thoughtfully finance your ADU in order to ensure the success of your project. Make sure to secure financing to cover construction as well as any unforeseen costs. There are a variety of financing options available to homeowners interested in building ADUs.
Before approaching a lending institution, it is important to have an idea of estimated costs, a timeline for completion, and any information on contracting services you intend to use. The institution will assess your home equity, assets, and income, and will also consider aspects of your project that make it more viable, such as the expected increased value or potential revenue. The more information you have about your project, the easier the process of securing financing will be. It is also important to seek out lenders that have experience with ADUs. While you should always speak to your lender to ensure you have the information you need and fully understand your options, below are some examples to help you better understand some of the products available on the market today.
Home Equity Loans & HELOC
A home equity loan is a loan that allows homeowners to borrow against their home’s value, minus what is owed on the mortgage. You gain access to your home’s stored value, which includes the amount the home has appreciated in value, and how much of the mortgage you have paid off. Home equity loans typically provide a fixed amount of cash with a fixed repayment schedule, using your property as collateral.
A Home Equity Line of Credit (HELOC) is also backed by your home’s equity and use your property as collateral, but is structured as a revolving line of credit. They typically have shorter repayment terms, and charge interest only on the amount drawn from the line of credit.
Example: If your home is valued at $400,000 and your mortgage balance is at $300,000, your equity is estimated at about $100,000. A home equity loan will generally allow you to borrow about 80% to 85% of equity. If your lender allows you to borrow 80% of the equity value, your possible loan amount would be $80,000.
Cash-out refinancing replaces your mortgage with a new home loan, with a higher balance than what you currently owe on your home. The difference between what is owed on the mortgage and the home’s value, goes to the borrower. An important note is that equity must be built on the home in order to use this option.
Example: If your home is valued at $300,000 and your mortgage balance is $200,000, your equity is estimated at about $100,000. If your bank is willing to provide a new mortgage at 80% loan-to-value, then you will receive a new mortgage of $240,000. This means that you will have $40,000 of your equity to apply toward your ADU. Note that this example does not account for closing costs or other bank fees.
Cash savings is one the best ways to finance your ADU; however, most homeowners cannot completely rely on their savings. It is important to have some cash to cover upfront expenses such as design and architecture fees, as well as permitting and required testing. Homeowners should be mindful that challenges may arise, as with any building project, which could result in a loss of invested funds.
Construction loans generally pay for plans, permits and fees; labor and materials; and closing costs. If a borrower wants to build an ADU on their property and does not have sufficient equity based on the current home value, the construction loan looks at the appraised improved home value, once construction is done, instead of the current home value.
There are two main types of construction home loans. The first is a construction to permanent loan where the money borrowed to build your ADU turns into a permanent mortgage with a term of 15-30 years, with a fixed-rate or variable-rate mortgage. There are also construction only loans, where a loan is taken only during the construction of the ADU. Once completed, a permanent mortgage is taken out to pay off the construction.
Example: If your home is valued at $300,000 and your bank were willing to lend 80% loan-to-value (ltv), then your new mortgage would be $240,000. If your appraised value after improvement is $360,000 and your bank were willing to lend 80% ltv, then your new mortgage would be $288,000.
Personal Line of Credit
A Personal Line of Credit is often offered by Banks to borrowers with good credit scores and income. These lines are typically free to set up and can range from $10,000 - $50,000 They do not require as much documentation as a HELOC, but hold higher interest rates than a mortgage.
Investments / Retirement Accounts
An option is to use cash from retirement and investment accounts, however there may be associated costs or early withdrawal penalties. Make sure that you understand the terms of your investment and retirement accounts to minimize fees and penalties, such as those associated with IRAs and 401Ks. Money can also be borrowed against a 401K, which is usually up to 50% of your vested account balance, but you should check what terms and limits apply to your plan.