An accessory dwelling unit, often abbreviated as ADU, can be a great way to increase the market value of your home, create some extra space, and generate some side income through rent. So it’s no surprise that ADUs have been growing in popularity in many parts of the country.
If you want to build an ADU on your property for some extra living space – or an additional source of income – then you’re in the right place. In this article, we will help you understand what exactly an ADU is, what benefits it can offer, and most importantly, how to get the financing you need to construct an ADU on your property.
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What Is An ADU & Why Do You Need One?
An accessory dwelling unit (or ADU) is a separate, independent house or studio that is located on the same plot of land as a larger, single-family home. The ADU can either be attached to or detached from the primary residence. Most ADUs have their own kitchen, bathroom, and living area. Ideally, they should also have an entrance that is separate from that of the main house, in order to maximize privacy and convenience.
While a certain amount of separation from the primary residence is expected, an ADU must share the same address as the main house. If two houses on the same plot of land have separate addresses, then neither of the two dwelling units can be considered an ADU. Instead, both structures would be part of a two-family property (like a duplex, for instance), as opposed to a single-family home.
Furthermore, an ADU would not typically have its own utility meter separate from that of the main house. (While it is technically possible to install a separate meter in your ADU for utilities like gas and electricity, it is rare because doing so can be prohibitively expensive, to the tune of $2,000 to $4,000, depending on where the house is located. So most people who rent out an ADU will estimate the ADU’s average utility bills, and include that in the tenant’s monthly rent.)
You may build an additional dwelling unit to have some extra space for work and recreation. Many people build ADUs on their property to provide a separate living space for an elderly parent or an adult child living at home.
If you don’t have any use for it yourself, an ADU can also be rented out to a tenant for some extra income every month. Lastly, an ADU will increase the resale value of your home by a significant margin, usually giving you a pretty good return on investment.
ADU Cost And The Possible Need to Finance
There are many good reasons to construct an ADU, especially if you have some extra, unused land surrounding your home. However, such a project can be quite expensive. An ADU will usually cost anywhere around $150-$300 per square foot, meaning that a modest, 750 square foot dwelling will set you back over $150k, in most parts of the country.
The cost of your ADU will also depend on whether it is attached to the main house or is a detached, stand-alone unit. Detached ADUs, typically set a few feet away from the primary residence, are more expensive to build than the ones that are attached to the main house.
On the other hand, ADUs built by converting a pre-existing garage or basement are some of the most affordable. To get an exact estimate of the potential construction costs, you should consult a contractor with experience building similar ADUs in your area.
While wealthier homeowners may be able to pay for the construction of an ADU out of their own pockets, this would not be a viable option for most people. So, if you need a way to finance your ADU project, then check out the options below.
1. Home Equity Loan
Also known as a second mortgage, a home equity loan is one of the most common ADU financing methods. However, you can only qualify if you either own your property outright, or have sufficient equity in it to borrow money against.
A home equity loan will allow you to borrow a fixed amount of money, which you will then be required to repay on a predetermined schedule. Second mortgages usually have a repayment schedule of around 10 years, shorter than the typical 30-year first mortgage.
Usually, a second mortgage will also have a higher interest rate than a first mortgage. You will also need to pay the lender fees, appraisal fees, title, and credit report fees for such a loan, as well as the typical closing costs.
Since the addition of an ADU will increase the market value of your home, while also helping you earn some extra income through rent, it makes sense to leverage the value of your home to finance the construction of the ADU. The fixed amount of cash, and the predetermined repayment schedule, can make budgeting easier and minimize the risk of a default.
One of the major advantages of a home equity loan is that they have a lower interest rate than most other types of loans. They also have a fixed interest rate, which makes the process of repayment more predictable and less complicated. Second mortgages can also, sometimes, be tax deductible, which means that they will help lower your overall tax burden for many years to come.
2. Home Equity Line Of Credit
HELOC stands for Home Equity Line of Credit, and is structured as a revolving line of credit offered against the equity that the homeowner has in their property.
If you don’t know exactly how much money you will need to finance your ADU project, then a HELOC might be your best bet, since you will only need to pay interest on the cash that you have withdrawn and used, instead of the entire loan amount, as would be the case with a second mortgage.
However, you should keep in mind that the interest rate is variable in the case of a HELOC, and the payment schedule is usually around 10 years. You do not need to pay any extra fees to withdraw cash (up to a set limit), as and when you need it. Most lenders will set a limit of 80 to 85 percent of the value of your property, minus the amount still owed on your first mortgage.
One of the major reasons for the popularity of HELOCs is that they often involve no closing costs or other fees. They also have the same tax advantages as a home equity loan, which means that the interest you pay on a HELOC is usually tax deductible, as long as you are using the money on home improvement projects, such as the construction of an ADU.
The only drawback to a HELOC is that the interest rates are variable, and can therefore rise unexpectedly. This means that you have to pay constant attention to the state of your loan to avoid being suddenly saddled with higher interest payments.
3. Personal Loan
Many homeowners take out unsecured personal loans to pay for home renovation projects, including the construction of an ADU. The interest rates for such personal loans are much higher than for a secured loan, such as a second mortgage or a HELOC.
However, personal loans are easier to obtain and do not require any collateral (unlike in the case of home equity loans, where the property itself is held as collateral against the loan). Therefore, personal loans are considered to be less risky, as you wouldn’t lose your home if you happened to default on the loan for some unforeseen reason.
You do need a relatively high household income and a great credit score in order to qualify for an unsecured personal loan that is substantial enough to cover the construction of an ADU.
Ideally, you would only use personal loans to cover the gap between the cost of your ADU and the amount you can borrow through home equity loans and HELOCs.
Hence, a personal loan can be used to pay for initial expenses like architectural drawings, permitting and appraisal fees, etc. If you used a personal loan to finance the entire ADU project, the cost of your ADU would skyrocket due to the extremely high interest rates.
A personal loan should only be used as a temporary solution for relatively minor construction expenses, when other sources of ADU financing are unavailable. The application and approval process for these loans is quite simple and straightforward, so they are a great way to obtain quick funding.
4. Cash-Out Refinance
Cash-out refinancing might be an excellent option for you, if you want to consolidate your loans or change your mortgage provider. This type of loan will allow you to replace your existing first mortgage with a new one, while taking out some of the equity you have built up in your home as the cash you need for the construction of your ADU.
You will receive a one-time, lump-sum payment, which will have to be repaid over time along with your monthly mortgage payment. This will allow you to consolidate the expenses incurred for the ADU project into your existing mortgage, instead of having to manage multiple loans obtained from different sources.
The more equity you have in your home, the higher the amount of money you will be eligible to receive through a cash-out refinance. This can limit your borrowing power, but this type of loan has a relatively low interest rate and can help you improve your credit score with minimal risk.
This is the perfect ADU financing option for those who got their first mortgage when interest rates were much higher, as refinancing the loan might potentially allow you to get a lower interest rate this time around.
The interest rate for a cash-out refinance can either be fixed or variable, so be sure to talk to your lender before deciding which of the available options is more suitable for you.
5. Construction/Renovation Loan
A construction or renovation loan is a good way to finance the development of your ADU, particularly if you don’t have sufficient equity in your home to qualify for some of the secured loan options, like a HELOC or a cash-out refinance.
Before the loan is granted, an appraiser will assess the projected value of the property, once the ADU has been built. The loan will be granted on the basis of the future appraised value of the home (including the ADU), instead of its current value. Since the ADU, once constructed, will enhance the overall value of your property, this will allow you to qualify for a larger loan than you would otherwise have been eligible for.
The total loan amount will not be handed over to you all at once. Instead, the lender will disburse it over a predetermined length of time, while an inspector regularly checks on the progress of your ADU construction project. The General Contractor selected to handle the construction of the ADU will also have to be approved by the lender before the building process can begin.
The regular inspections are meant to protect the lender as well as the borrower. You will get regular oversight and guidance throughout the ADU construction project, ensuring that everything works smoothly until the entire loan amount has been released and the project is complete.
Construction loans involve stringent requirements, making the application process quite complex. You will have to arrange regular inspections during the construction process, submit a draw schedule obtained from your contractor, and share constant updates regarding the progress of the ADU with your lender.
6. Retirement Account Loan
Retirement accounts like a 401k or IRA can be a viable source of financing for your ADU project, although this should only be considered a last resort. You can borrow funds – up to 50 percent of the total value of your 401k, for instance – to fund the construction of the ADU. This investment might be justified if you expect to earn regular rental income from your ADU.
You can also withdraw about $50,000 USD from your IRA, although this will probably not be enough to entirely finance the construction of an ADU. If you are below the age of 59 ½, you may have to pay a withdrawal penalty for borrowing money from a retirement account. Additionally, any money you borrow from your 401k should be repaid within five years.
Once you have secured the funds needed to build your ADU, you can start talking to architects and contractors who will help you plan and execute the construction project.
We hope you’ll find an option that works for you from the above list.