ADU Financing Options in California

ADUs (Accessory Dwelling Units) are becoming increasingly popular. These additional living spaces, also known as granny flats, carriage houses, or backyard cottages, share the same lot as a single-family home. They are encouraged by the federal government and various states and localities to address affordable housing shortages. The mortgage industry is also adapting to support ADU construction. 

Despite this encouragement, many homeowners faced challenges in fulfilling their ADU dreams due to limited financing options. Fortunately, the rising demand for ADUs has led to an array of funding opportunities. 

We are here to guide you through ADU financing, assisting you in selecting the optimal option for your needs. 

ADU Loans and Financing Options 

Several ADU financing options rely on factors like your primary home’s equity, household income, and credit score. However, these traditional options often fall short of covering the full cost of ADU construction. 

Fortunately, a few alternative options are there, allowing you to secure loans based on the future value of your home. 

Before you commit to a financing route, learning more about your ADU’s intended use is crucial. Renting out the ADU can help you repay the loan or generate a positive income stream. 

For example, rental rates for a new ADU accommodating a two-person family in California range from $1900 to $2300 per month. 

Considering these factors, let’s explore the following options for financing an ADU construction: 

1. Home Equity Loans and Lines of Credit (HELOCs) 

Utilize your home equity to finance your ADU through a second mortgage—a one-time loan or a home equity line of credit (HELOC). With a home equity loan, you receive a lump sum to repay in fixed installments.  

HELOCs operate similarly to credit cards, allowing you to borrow money as required, featuring a variable interest rate. Importantly, home equity loans do not substitute your existing mortgage, thus maintaining the terms and interest of the first mortgage unchanged, a favored choice for numerous homeowners. 

2. Unsecured Loans 

Unsecured loans, also known as Personal loans, rely on the borrower’s creditworthiness rather than any collateral like property. 

One advantage of opting for an unsecured loan for your ADU financing is that it keeps your assets safe. Another benefit is the streamlined application process. 

However, because these loans pose a higher risk for the lender, they typically come with higher interest rates and payments, and the borrowing limit is usually smaller. 

If your ADU project is relatively straightforward, such as a garage conversion or a studio, an unsecured loan can be a favorable option for you. 

3. ADU Home Equity Share Investments 

A home equity share agreement simplifies access to your equity without loan complexities. With this concept, an investor offers up to $500,000 for your ADU, exchanging it for a share of your home’s future appreciation. 

 If you are ineligible for other loans or prefer to avoid additional monthly expenses, this ADU financing option might be suitable for you. 

This financing approach hinges on the anticipation of property value increase, circumventing traditional criteria such as credit scores or DTIs. 

4. Cash-out Refinancing 

Cash-out refinancing helps you to convert your home equity into cash by securing a new mortgage exceeding the balance of your existing one. 

This process enables you to pay off your initial mortgage while directing the surplus towards ADU financing, consolidating both your primary mortgage and ADU funding into a unified loan. 

Homeowners with significant equity in their residences benefit from cash-out refinancing. Ideally, you should have around $200k in Home Equity to cover typical ADU expenses. It’s crucial to understand that cash-out refinances usually allow access to only 80-90% of your equity in cash. Opting for a cash-out refinancing loan requires adjusting your primary mortgage interest rate, often leading to a higher rate. 

5. ADU Construction Loans or Renovation Loans 

Equity loans specifically designed for renovation projects include construction and renovation loans. 

These loans offer a primary advantage: they enable borrowing based on the anticipated future value of the home post-renovation, such as ADU construction. 

Many homeowners opt for the Fannie Mae Homestyle renovation loan for ADU projects due to its potential for qualifying them for substantial amounts, providing increased borrowing capacity to cover the $150-$200k ADU construction cost. 

In these loans, homeowners often encounter complex administrative requirements, resulting in prolonged closing times. Additionally, they carry a high denial rate, with 45% of applicants rejected compared to just 18.4% for cash-out refinance borrowers. 

Steps to Securing an ADU Loan 

ADU financing options vary by state and city. In California, where ADUs are highly sought after, some municipalities actively provide incentives and financing programs to promote construction.  

Regardless of your location, securing your ADU loan involves a few common steps: 

1. Determine Loan Amount 

First, prioritize figuring out your budget. Consult a financial advisor regarding your financial goals to gain clarity on your affordability. Determine the amount your loan should cover, then solicit 3-4 estimates from local contractors based on your ADU wish list. This process will assist you in determining the necessary borrowing amount. 

2. Assess Eligibility 

Several mortgage calculators exist to assist you in understanding your eligibility. You will need to input information such as your Debt-to-Income (DTI) ratio, FICO score, annual income, property type/location, etc. The calculator will provide an estimate of your borrowing capacity.  

3. Research Lenders 

Reach out to your friends and family for referrals to reputable lenders in your area. Conduct thorough research to identify lenders offering various loan types, rates, and potential discounts or programs to maximize your project’s value and minimize loan costs.  

4. Gather Documentation 

To determine your eligibility, your lender will require proof of all the information. Here is what you will need to provide: 

• 2 Most Recent Pay Stubs 
• 2 Years of W-2 Forms 
• Proof of Homeowners Insurance 
• Most Recent Mortgage Statement 
• Statements for Personal Bank, Retirement, and Investment Accounts 
• Contractor Information 
• Detailed Cost Estimate for Appraisal 
• Renovation Plans (blueprints, drawings, contracts, etc.) 

5. Apply for the Loan 

Once you have gathered all your information and chosen the loan you wish to finance your project, it is time to act! Complete an application and submit it to your lender. Most lenders charge an application fee, and they may pose various questions to confirm your details before you sign. 

Conclusion 

Building an ADU presents an exciting opportunity, allowing you to introduce an additional income stream or enhance the functionality and value of your home. However, for many homeowners, navigating the smartest financing options for an ADU can add complexity to the process. 

Before deciding, assess your funds, home equity, and credit score against your project budget. 

Meanwhile, BFPM stands ready to assist you in keeping up with the latest ADU opportunities. 

If you are still uncertain about these financing options, check your eligibility for CalHFA’s ADU Grant Program, which can supplement your ADU funding by $40,000. 

Reach us at BFPM for more information on Accessory Dwelling Units(ADU).