As you start planning your ADU project, one of the first questions you’ll have to answer is how to pay for it. While an ADU can help you generate rental income and increase the value of your property, building an ADU is a pricey undertaking, especially considering that the cost of building materials has escalated in the post-pandemic economy. So it’s important to know your financing options and compare lenders, just as you would if you were buying a car or a home.
Budgeting for an ADU
A good first step is to plan out a simple project budget. You can expect to pay about $250-350/sqft for an ADU that’s built in converted space, and about $350-450/sqft for an ADU that’s built in new space. So a typical 1-bedroom, 600 sqft ADU will cost between $150,000 and $270,000. This ballpark estimate includes soft costs (a survey, designs, permit fees, etc.) and hard costs (lumber, appliances, labor, etc.)
For a more precise estimate of project cost, check out our ADU Budget Calculator.
It’s also wise to have cash savings to put towards the ADU project, even if you plan to pay for most of the project with a loan.
- Having cash on hand will help your project move faster — for example, you can pay for a contractor site visit, designs, and permits while you’re waiting for a loan to close.
- Many loan products will require a down payment, and may include upfront fees or other closing costs. Having cash reserves may also help you access lower interest rates.
- You can use cash savings to pay for a contingency in your budget — essentially, a small reserve fund that you can use if there are cost overruns.
Your lending options
Of course, few of us have enough cash savings to pay for an entire ADU project, which is why most homeowners get a loan to finance their ADU. While you have many different financing options available, each lending product comes with its own pros and cons. The right choice depends on your individual financial situation, your home’s value, and the amount of debt you already have outstanding on your home.
Commonly used lending products include:
- Cash-out refinance
- Home equity loan
- Home equity line of credit (HELOC)
- Renovation loan
- Construction loan
- Private money
A short summary of loan products for financing an ADU
Cash-out refinance
A cash-out refinance is a type of mortgage that refinances your primary mortgage and uses your existing home equity to access cash to pay for construction. Essentially, you get additional cash while taking on a larger mortgage. Cash-out refis typically allow you to borrow up to 80% of your home’s current value. You pay the loan back over 15 to 30 years, just like a standard mortgage.
Cash-out refis come with significant advantages, especially for borrowers with good credit and high home equity:
- Cash-out refis are widely available, tend to be quick to close, and have few fees.
- Relative to other major lending products, you’ll pay a moderate interest rate (about 0.5 points higher than a standard mortgage). The interest rate is fixed, so you’ll lock in a low rate as interest rates likely rise in the future.
- The use of funds is flexible — you pay the contractor as key milestones are completed.
However, this approach won’t work for everyone:
- If you don’t have much home equity (for example, if you only recently bought your home), a cash-out refi won’t provide enough cash to pay for an ADU project.
- Also, a cash-out refi is a new primary mortgage, requiring you to retire your current mortgage. If you’ve recently refinanced your existing mortgage and locked in a low interest rate, you may not want to retire your current mortgage.
Home equity loan
A home equity loan is a type of second mortgage that you carry alongside your existing mortgage. Like a cash-out refi, it uses your existing home equity to access cash to pay for construction. You can typically borrow up to 80% of your home’s current value.
Once the loan closes, your lender will pay you the total loan amount, so it’s a good idea to determine your budget before applying for the loan. You pay the loan back in consistent monthly payments (both interest and principal) over 10-30 years.
Home equity loans are a great option for borrowers with good credit and high home equity:
- They’re widely available, and quick to close.
- Relative to other major lending products, the interest rate is moderate, and the interest rate is fixed.
- The use of funds is flexible - you pay the contractor as key milestones are completed.
- Crucially, you don’t have to retire your existing mortgage in order to get a home equity loan — a major plus if you’ve previously locked in a low rate on your mortgage.
However, if you’re a relatively new homeowner without much home equity, a home equity loan probably won’t provide enough cash to pay for an ADU.
Home equity line of credit (HELOC)
A home equity line of credit (HELOC) is very similar to a home equity loan; it’s a second mortgage that taps your existing home equity for cash.
A few key differences:
- A line of credit gives you the right to borrow up to a predetermined amount, but you don’t have to borrow it all at once. Instead, you withdraw funds as project milestones are achieved, and you only pay interest on the amount you withdraw.
- During a “draw period” of 5-10 years, you only pay interest. Then, during a repayment period of 10-25 years, you pay the loan back in consistent monthly payments (both interest and principal).
- HELOCs typically have a variable interest rate, which means that your monthly payments will increase if interest rates rise in the future.
As with home equity loans, HELOCs are a great option for borrowers with good credit and high home equity. They’re a less effective option for relatively new homeowners without much home equity.
Renovation loan
A renovation loan is a type of mortgage that provides funding for home renovation, as well as for the purchase or refinance of the home itself. If you already own your home, it replaces your existing mortgage and provides you with the cash needed for the ADU project. You’re charged a relatively low fixed interest rate, and you pay the loan back over 30 years, just like a standard mortgage.
Two commonly-used renovation loans are the Fannie Mae HomeStyle and the FHA 203(k) loan.
Unlike other loan types, renovation loans allow you to borrow about 95% of your home’s value post-renovation (essentially, what the home will be worth with an ADU). If you don’t have much home equity, this can help you access enough funds to finance ADU construction. This can also be a good option for homeowners who don’t have high credit scores.
However, renovation loans can be challenging:
- Relatively few lenders offer these loan products - you’ll have to shop around and contact multiple lenders.
- You’ll have to refinance your existing mortgage to pay back the construction loan. If you have a low interest rate on your mortgage, you may not want to retire your current mortgage.
- They’re often slow to close - expect the process to take up to 90 days. Delays are common, especially when a lender lacks experience with renovation loans.
- Before the loan is approved, a third-party consultant will have to approve your contractor’s budget, and the lender will want to see that the city has approved your building permit. This can slow down the loan closing process.
- The lender is unlikely to let you change the project budget after it’s locked in. You may have to pay out of pocket for cost overruns.
- During construction, the third-party consultant has to certify that key milestones are met before the lender will approve payments to the contractor (the “draw schedule”). This can slow down contractor payments (and the next stage of construction), which is why some contractors avoid projects that are financed with a renovation loan.
Construction loan
A construction loan is a short-term loan (typically 1-2 years) that can provide financing for building an ADU. Like a renovation loan, a construction loan is based on an estimate of what the home’s value will be after the ADU is completed. This allows you to borrow up to 80-95% of the home’s value post-construction.
There are two main types of construction loans:
- Construction-to-permanent loan: this loan provides funds for ADU construction, and when the project is complete, the loan converts to a standard mortgage with a 15-30 year term. Since it’s a single loan product, you only pay closing costs once.
- Construction-only loan: this loan also provides funds for ADU construction. At the end of the term (1-2 years), the borrower must either pay the loan back in full or get a mortgage or home equity loan to provide permanent financing. While this allows you to shop around for permanent financing (and avoid retiring your primary mortgage if you refinance into a home equity loan), you’ll pay closing costs twice.
A construction loan can be a good option for homeowners without high home equity. Additionally:
- Construction-to-permanent loans issued by credit unions often have low interest rates and can offer fixed rates, allowing you to lock in low rates over the long term.
- As with HELOCs, you withdraw funds as project milestones are achieved, and you only pay interest on the amount you withdraw. You don’t have to pay back principal until after the project is completed.
However, construction loans aren’t for everyone:
- Interest rates vary widely, and construction-only loans tend to have high interest rates.
- Relatively few lenders offer construction loans - you’ll have to shop around and contact multiple lenders.
- Before a lender will issue a construction loan, you’ll need a home appraisal confirming that an ADU will add significant value to your property. ADU appraisals are sometimes inconsistent and have historically undervalued ADUs (particularly those that convert existing living space).
- Your ADU project must be completed by the end of the term of the loan.
- A construction-to-permanent loan will retire your current mortgage once the project is complete. If you have a low interest rate on your mortgage, you may not want to retire your current mortgage.
Private money
Private money is similar to a construction-only loan: it refers to a short-term loan (typically 1-2 years) that’s used to finance ADU construction, and is paid back at the end of the project, typically by refinancing into a standard mortgage. However, while construction loans are issued by banks and credit unions, private money comes from private investors — this could be family, friends, accredited investors, or private money lenders (“hard money” lenders).
Private money can make sense for some groups of property owners, particularly owners of investment properties who want to add ADUs to a rental property. However, these can be very risky loans for most homeowners: interest rates are generally high (between 6-12%), and you will have to put up property (most likely your primary residence) as collateral. Standard lending products, like cash-out refis, home equity loans, renovation loans, and construction loans, typically offer much more advantageous terms.
Where to find ADU loans
Before choosing a loan to finance your ADU project, it’s very important to shop around to find the product that’s right for you, as well as the best terms.
A few places to start:
- Your current bank likely offers cash-out refis and home equity loans/lines of credit. If you already have a mortgage with the bank, they may be able to offer you competitive terms.
- Online loan aggregators, like NerdWallet, Bankrate, and CreditKarma, make it easy to compare terms for different types of loans.
- Independent mortgage brokers often have access to better pricing and loan terms, particularly for less common lending products. Revival Homes can connect you to our partner independent mortgage broker.
How Revival Homes can help
We’re here to support you at every stage of your ADU project. You can get started today by scheduling a free consultation with a Revival Homes ADU expert. We’ll help you create a project plan, a budget, and a strategy for financing your ADU, and we’ll answer any questions you have about this article. We’ll also connect you to an independent mortgage broker, who can help get you the loan product that’s right for your needs.
For more information on ADU financing, check out the Casita Coalition’s ADU Finance Guide for Homeowners.
