Real Estate Agency. Young Couple Signing Financing Contract

How to Finance Your ADU

Accessory dwelling units (“ADUs”) are all the rage. In the era of work from home, homeowners are adding much needed space to their properties. Whether it’s a home office, lodgings for aging parents, or a rental unit, ADUs add incredible intrinsic and economic value. If you are reading this, you likely understand that value and have a specific use in mind. However, there is one obstacle standing in your way: cost

As the saying goes, “cash is king.” If you are sitting on a pile of cash but wondering just how much you’ll need, ADUs can range from $150,000 to more than $400,000 all-in. Cash provides the most flexibility in terms of timeline. No waiting for sign-off from a lender. No extra hoops to jump through. With cash, your ADU builder can move forward with the designs and proposed construction documents right away. However, if you cannot pay with cash, all is not lost. See the below for ways that you can still build your dream ADU.

A cash-out refinance is a mechanism to utilize the equity that many homeowners have built-up over the years. As real estate prices continue to rise, more and more Americans have untapped equity in their homes than ever before. For many homeowners, a cash-out refinance will open up vast equity reserves that can cover the full cost of an ADU.

These loans are your typical mortgage, and have a fixed rate and a 30-year amortization. The loans include closing costs associated with a refinance, which are rolled into the new loan amount and are not required to be paid out of pocket. Most cash out refinances can go to 80% of the appraised value of the home.

One of the most compelling benefits to a cash-out refinance is the interest rate. Interest rates are currently near historic lows. A cash-out refi not only opens up access to equity but can potentially lead to a lower rate than one’s current mortgage.

For any homeowner who is looking to build an ADU, a cash-out refinance remains a highly compelling option.

A home equity loan is essentially a second mortgage on one’s property. This type of loan will allow you to borrow a certain dollar amount of cash based on the equity that you have in your home, which is repaid on a schedule.

The upside of this approach is that it leaves your original mortgage in place. If you have a great rate on your first loan, and a cash-out refinance would raise your rate, this is a great option. The
downside is that the interest rate on this second loan will likely be at a higher rate than your first
mortgage and is subject to various fees and closing costs.

A HELOC (Home Equity Line of Credit) allows a homeowner to borrow against the equity in their home and provide a revolving line of credit. Under such a revolver, interest is only payable on the cash that you have drawn on.

This option is available to homeowners with equity in their homes

One of the downsides is that the interest rate will more than likely be higher than on your first mortgage and may be a variable rate. Lenders typically lend up to a maximum of between 80% and 85% of the value of your home, minus the dollar amount of any existing mortgage on the property.

A construction loan is an option for homeowners who have less equity in their property. 

A construction loan allows a homeowner to borrow on the future value of the home, including the value of the proposed project. As one can imagine, the future value of a project can be difficult to pin down. This generally translates into a higher interest rate given the uncertainty of that future value.

This uncertainty can be mitigated by working with an ADU builder who builds multiple units of the same model. A lender is more likely to give a better interest rate for a proposed project if that project has been done before.

Construction loans likely have higher closing costs, based on the new value of the mortgage and budget, and involve some legwork for both the homeowner and builder. The extra work comes from a draw schedule, potentially additional inspections, and reporting requirements to the lender.

Building an ADU can be challenging but is certainly a rewarding endeavor. Cedar ADU is always available as a guide to answer questions or give insights on how one might finance and build an ADU.

Disclaimer: Default numbers are estimates. Enter numbers that match your location or confirm with lenders for the best result.