How to Finance an ADU or Garage Conversion

By Samuel Schneider

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04.29.2021

Introduction

Obtaining financing is often the biggest obstacle facing prospective ADU builders, according to a 2020 paper from UC Berkeley’s Terner Center for Housing Innovation. Following California’s loosening of restrictions on ADU construction, a growing number of homeowners are choosing to increase their property value and expand their income potential by building a granny flat. However, building an Accessory Dwelling Unit is much more complex than your standard home renovation project. 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 an ADU on your property without high amounts of available home equity, household income, savings, and/or an immaculate credit score. But don’t lose hope! This simple guide will walk you through your financing options and help you determine the best choice for your little dream house.

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. Unlike taking out a second mortgage, this option allows you to consolidate your ADU financing and your mortgage into a single loan. The downside is that it requires a large amount of established home equity, and most cash-out refinances only let you borrow up to 80% of your current property value. Cash-out refinancing is the cheapest way to build an ADU—but only if you get a lower rate than your current mortgage, and the closing costs are worth the long-term investments.

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. The downside of traditional home equity loans is that they are determined by the current value of your home, without considering the future value once the renovations are complete. But renovation loans allow you to borrow based on the future value of your home once the renovations are complete. At Homestead, we partner with Renofi to help you make the most of your borrowing power. Renofi Loans are a great choice for most folks with existing income looking to build an ADU, as they enable homeowners to credit the value of their future renovation towards the maximum amount they are allowed to borrow. And because ADUs always add value to your home, you can borrow more with Renofi than with a traditional Home Equity Loan. They also bypass expensive closing costs, so all you have to pay for is the appraisal (which costs less than $500)!

For example, let’s say your house is worth $1,000,000 and you have $850,000 of outstanding loan principal. With a regular home equity loan, you’d only be able to borrow $50k to finance your ADU. However, the in-law unit you’re building will add $200k to your home's value. Renofi Loans allow you to borrow up to 90% of your post-renovation value, so you can borrow up to $230k with Renofi!

Bonus points for RenoFi: they allow borrowers to choose their own repayment terms, up to 20 years. This is pretty great, since most renovation loans come with limited and less flexible repayment terms. And RenoFi offers a much higher LTV (loan-to-value) than traditional refi or equity loans.

Home Equity Loans and Lines of Credit (HELOC)

A home equity loan--also known as a second mortgage--lets homeowners borrow a predetermined amount of money based on the equity of their home. In most cases, the maximum amount is 80-85% of your home’s value, minus the outstanding first mortgage. When you work with Homestead and our partner Point, you can access 85% of your equity and close in under three weeks.  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. Home equity loans and lines of credit can be a good option for people with high home equity but lower cash flow. However, they can be limiting depending on your circumstances. Most lenders don’t take future property values into consideration when determining loan/credit amounts, so you won’t be able to borrow as much as you would with a Renofi Loan. And if you’re a relatively new homeowner and haven’t paid off much of your mortgage yet, the amount of equity to borrow against probably won’t be enough to cover the full price of ADU construction, including closing costs and other fees.

Another thing to keep in mind: interest rates for a second mortgage are higher than those for a first mortgage, so it’s wise to factor that in when making your decision. It’s also likely to be a variable rate, which means it might even increase over time.

Home Equity Investments

Home equity investments (HEIs) are another financing resource for ADU projects. Until recently, it wasn't possible to access your home's equity without taking on debt. Adding debt—especially mortgages—can be difficult for people with alternate incomes, retirees, or those whose monthly debt payments exceed 45% of their income.  Companies like Point and Unison have created a new way to unlock your home’s wealth with HEIs.

Here's how it works: 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 (they even cover the assessment!) 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!

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.

Financing options to avoid

While the above financing options have their respective pros and cons, they are all legitimate borrowing methods. There are other options out there that you'd be better off avoiding, like construction loans. Not to be confused with renovation financing, construction loans are a popular but less-than-ideal choice for a wide array of home improvement projects, including ADU construction. They seem like a good idea because they allow you to borrow based on the projected value of your home, post-renovations. 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. Spare yourself the headache.

Many homeowners with lower home equity choose to take out personal loans and credit cards to pay for ADU construction, simply because they are uninformed about other options. Personal loans can be a reasonable short term solution, provided you follow quickly with a refinance or HELOC. But homeowners should never use a credit card to fully finance an ADU construction, as they are unsecured and often come with high interest rates. 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. Even if you do qualify, you’ll end up spending way more in the long run. So if you're low on home equity, choose an HEI instead.

Some contractors try to sell homeowners on PACE (Property Assessed Clean Energy) Loans, but beware: these risky, quickly approved loans 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 loans are actually illegal to use for building ADUs. Don't ever let someone sell you on one; it's fraud. Find another way to finance your granny flat!

How do I choose?

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! Homestead 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.

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About The Author

Sam is a graduate of MIT's School of Architecture and Planning. He became fascinated with ADUs in 2017 when he realized that they were the fastest solution to California's housing crisis. Now, Sam is focused on helping Los Angeles homeowners add ADUs through his work with Homestead.
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