How to Finance an ADU

Garage conversions, basement apartments and guest homes. What are the options for financing, and what's right for you?

There is a lot to figure out when you are deciding to move forward with your ADU project. Attached or detached, zoning codes, permits, design, contractor estimates, the list goes on.

But without the proper financing, your project will grind to a screeching halt. With the recent rise of ADUs in California, lenders and banks are just now struggling to catch up to growing demand and specific loan products tailored to ADUs still have yet to be developed. Most homeowners today, rely on savings or home equity to pay for their projects.

In this article, we will review the top ways to finance your ADU project as well as advice about how to communicate with lenders effectively about your goals for the project.

Home Equity Loans & HELOCS

Home equity is the most common way for homeowners to finance their ADU project. It makes sense to leverage the stored value in your home when planning to make improvements to it that will ultimately cause it’s value to rise. When adding in the income that the ADU could generate in the years to come, home equity financing becomes a smart choice for many homeowners who need loans to build ADUs.

Home equity financing comes in two typical flavors; Home Equity Loans, which provide a fixed amount of cash available to you with a fixed repayment schedule, and is backed by the equity you own in your home. And Home Equity Line of Credit (HELOCS) which are also backed by the equity in your home, but are structured as revolving lines of credit that have shorter repayment terms and only charge interest on the balance you have drawn on the line.

While both options provide a clear path to financing for your ADU project, each product is more suited to specific situations, so it important to evaluate the expected timelines and cash outlays required for your project before deciding which product is the best fit for you.

Cash-Out Refinancing

A second option which is similar to Home Equity Financing but structured differently is cash-out refinancing. If you would like to change your mortgage provider entirely on your existing home loan, get a lower rate, or consolidate the new project financing into your existing home loan, refinancing could be the best option for you. In cash-out refinancing, the lender will look at the current appraisal value of your home, compared with the principal value remaining on your current mortgage. If your home has increased in value substantially since your purchased it, then you may be eligible to refinance it for the current appraisal value and get cash out based on your new equity balance. Ask your prospective lender about qualifying for a cash-out refinancing as an alternative to home equity financing.

Peer to Peer Lending Showing Promise

In addition to traditional lending products like home equity and refinancing, the Peer to Peer lending space has begun to show promise in recent years. A few innovative models are beginning to appear which are focusing on financing for residential property and provide homeowners new alternatives to consider.

Point.com provides homeowners a way to sell equity in their home in exchange for cash to finance renovation projects. This is a new concept which the company is pioneering to enable homeowners to align their investment in an ADU with other real estate investors who share in the risk along side them.

Another provider of P to P real estate lending is PeerStreet.com, which is currently focused on the real estate development market. The company has established an impressive track record with investors and could be looking to expand it’s focus to provide lending to a wider range of real estate investments in the coming years.

Keep an eye on this space, especially is if you are planning for your project a few years into the future.

Good Old Savings Account

Cash is king, and of course if you’ve been able to save for your project over the years, then maybe jumping through all of the hoops required to get financing for your project is not worth the hassle. Not to mention, you could end up saving money in the form of premiums and opportunity cost while your money is tied up long term. Unfortunately, this is not the case for most homeowners who are otherwise perfectly qualified to build an ADU.

Many of the ADUs built today are financed mostly or entirely with the homeowner’s cash savings. The lack of specialized financial products for ADUs is a clear drag on the current production of ADUs in cities and something that we hope to help solve in the years to come.

If you are planning to build an ADU in the near term, it is certainly important to be sure that you have some cash savings in order to cover up front expenses for design, feasibility and permitting costs at a minimum, as these expenses could potentially be lost if the project turns out not to be feasible or the costs are outside of your original budget.

Communicate with Lenders About your Goals for the project

When communicating with lenders about your project, make sure to give them the facts of your situation, why you are building the ADU, eg. increased property value, extra income, or space for family and friends. Make sure that the use you are proposing is, in fact, allowed in your jurisdiction. It is also important to have a general understanding of how much the project is likely to cost, a timeline for permitting and completion and ideally the service providers that you plan to work with, eg. the architect and or contractors on the project.

Lenders will be looking at the usual suspects of your application: credit, home equity, assets and income. But they will also factor in aspects of the project that are relevant such as, expected value of the improvements to the home, and the income that it might generate. One other thing to declare would be if the improvement is expected to generate savings for your family, such as consolidation of your family's living expenses. An example of this would be constructing an additional bedroom for an elder to save money that would otherwise be spent on a nursing home