ADU Financing Strategies
When planning an ADU project, there are several financing options to consider, and the right one depends on factors such as home location, credit score, income, existing debt and available home equity. While there are several different financing strategies, below are the most commonly utilized by homeowners who we have worked with.
Cash-Out Refinance
Allows you to access equity in your by refinancing your existing mortgage. The money that you access from your available equity is combined into one new mortgage. You pay monthly payments of Interest and Principal each month for a set term and depending on the mortgage, it can be at a fixed interest rate or an adjustable interest rate mortgage. It is a very common strategy for homeowners but be mindful that if you currently have a low interest rate on your existing mortgage, you may not want to do a cash-out refinance as you will be subject to whatever the current interest rate is at the time you apply, which may be higher.
Home Equity Line of Credit (HELOC)
Allows you to access equity in your home through establishing a line of credit. A HELOC is a second loan that acts as a line of credit. A HELOC has a variable interest rate during the drawdown period (usually 10 years). During the drawdown period, you only have to pay interest on the amount of the loan that you have drawn at any given time. At the end of the drawdown period, the HELOC converts to a fixed rate loan where you will make monthly payments of interest and principal for the remaining term of the loan. It is also a very common strategy for homeowners to utilize on construction projects since you only pay interest on the amount of principal that you are using at any given time throughout the project. It is best to utilize a HELOC if you do not want to refinance your primary mortgage due to having a great interest rate.
Home Equity Loan or Second Loan
Allows you to access the equity in your home as a second loan. A Home Equity Loan or Second Loan has monthly payments of interest and principal that you will pay each month for a set term, 10, 15, 20 years. The interest rate is fixed throughout the life of the loan. It is best to utilize a second loan if you do not want to refinance your primary mortgage due to a great interest rate and you are not comfortable with a variable interest rate.
Construction Loan
Construction loans are a short-term financing option that can help you pay for construction costs when you build a new structure or add on to an existing structure. Construction loans require that you are project ready as they are time limited. Project ready means that you have approved permits, a contractor and a project budget. These loans must be paid back in full upon the completion of construction. Certain Credit Unions have created specific ADU construction loans that allow homeowners to become loan qualified based on the future value of the home once the ADU is completed as well as the future rent that might be possible for the size of the ADU. These unique loans support homeowners who may have sufficient income to qualify for the loan but not enough equity in the home to support the loan size they need or for homeowners who may have enough equity in their home, but not enough income to qualify. To pay off the construction loan at the end of the project, lenders may allow the loan to convert into a second mortgage loan or may allow homeowners to refinance the primary mortgage.
Renovation Loan
A renovation loan is a special type of mortgage that specifically includes funding for repairs or upgrades to the property, in addition to the purchase or refinance of the property itself. If you are buying a property and looking to build an ADU, then a renovation loan could finance both with one loan. Two of the most prominent renovation loan products are the 203(k) loan supported by the Federal Housing Administration (FHA) and the HomeStyle® loan supported by Fannie Mae. The Federal Housing Administration and Fannie Mae don’t directly issue these loans. Instead, a bank, mortgage broker, or independent loan agent will connect you with these loan products. Not all banks offer such specialized loans, so you may need to shop around to find renovation loan options. A 203(k) and a HomeStyle® loan have some key differences.
A 203(k) loan will typically have looser credit score requirements than a HomeStyle® loan, but a 203(k) loan is only available if you agree to live in either the ADU or main house. It is also unclear if a 203(k) loan can be used for a detached ADU. The loan requires construction work to be completed in a six-month period.
A HomeStyle® loan may have higher credit rating requirements, but it can be used to build any type of ADU and can sometimes be used on investor-owned or vacation properties. The loan requires construction work to be completed in a twelve-month period. HomeStyle® loans may involve paying less than a 203(k) loan in private mortgage insurance, especially if you have good credit.
401(k) Loan
Some homeowners can borrow from their 401(k) to pay for part of their ADU cost. Not all employers allow a 401(k) loan, but those that do will typically allow the lesser of $50,000 or 50% of the 401(k) balance to be borrowed within a 12-month period. These loans function similarly to a bank loan – you pay back the loan at regular intervals, and you pay interest on the money you borrow. However, your 401(k) receives both the repayment and the interest you pay. Therefore, you are essentially paying yourself back with interest. A homeowner’s ability to use a 401(k) loan depends on having money already in their 401(k) and on having a 401(k) that allows for loans (this varies from employer to employer). If you pay the loan back on time, you do not pay penalties like you would on an early 401(k) withdrawal. If you fail to repay the loan on time (typically over a 5-year period), the remaining loan balance will be taxed as an early 401(k) withdrawal.