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Financing An ADU (Auxiliary Dwelling Unit)

One of the biggest opportunities in today’s real estate market is to create an ADU (an Auxiliary Dwelling Unit) on your property.

What Is An ADU?

An ADU (the abbreviation for Auxiliary Dwelling Unit) is an extra place on your single-family home property where people can live. They go by many names, including

  • Mother in law apartment
  • Granny suite
  • Tiny home in your backyard
  • Remodeled garage
  • Backyard cottage
  • Etc.

Having an ADU on your property has many advantages, including:

  • Extra income through renting it out to others
  • A private place for loved ones to stay temporarily or long term
  • A quiet, private location for guests

Of course, these advantages also come with disadvantages, legal requirements, and lots of other questions which we have outlined in this article: Is Creating An Auxiliary Dwelling Unit (ADU) Right For You?

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Financing An ADU

To normal people, financing an ADU build or conversion seems like it would be simple: go to a mortgage lender, get a construction or remodeling loan, and you’re good to go. But oftentimes, that’s not the case.

By the way, if you’re looking to build or create an ADU, you should talk with us first. We work with lenders nationwide, many of whom specialize in non-normal loans, like ADU loans. Click Here to Get Matched with an Expert

The key factor in ADU financing is whether this is a new, separate building (a tiny house in your backyard) versus a remodel or an addition to an existing home. New, separate buildings can be funded through a construction loan. Remodels and additions are funded as a renovation loan, which has different loan options.

Financing A Construction Loan – An ADU Separate From Your Home

If you’re constructing a new building separate from your home, you may be able to qualify for a construction loan. 

Construction loans tend to be less expensive in interest rates (a small premium over traditional refinance rates), can feed money out in stages (so you don’t have to pay interest on the money until you need it as your construction progresses), and oftentimes have a conversion option allowing you to convert it into a permanent 30-year mortgage after the construction is completed. Some loans allow you to fix that permanent loan interest rate when you take out the construction loan, others convert at the prevailing interest rate at that point in time.

Part of the challenge of a construction loan is that there are a number of loan regulations that may affect your ability to get a loan, depending on the type of loan you are applying for (for example, if you’re applying for an FHA loan and the main property is a bed and breakfast, you cannot get an FHA loan for an ADU,) so be sure to talk with a lender before proceeding too far with your project.

Note also that an ADU separate from your home can also be financed through the types of financing used for renovations (see below) but not vice versa.

Financing A Renovation Loan For An ADU

Renovation loans are required any time your ADU will be attached to your existing home, like remodeling the basement to be an ADU, converting your garage into a habitable unit, or building an addition to your home.

Renovation loans are usually financed through:

Home Equity Line Of Credit (HELOC)

A HELOC is a revolving line of credit (meaning the lender determines the maximum amount of your loan, and you can withdraw any amount up to that total as needed at any time, including being able to repay part of that amount then reborrowing it when needed as long as you don’t exceed the maximum amount.)

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HELOC loans 

  • Are based on the equity you have in your home, so are usually only available after you’ve been in your home for some time and/or after your home has significantly increased in value
  • Tend to have a higher interest rate than traditional mortgage loans and are variable, meaning they will change as prevailing interest rates change
  • Are oftentimes 10-year loans – so your payment amounts will be based on paying off the loan within 10 years
  • Usually are limited to 80-85% of the current value of your home
  • Can usually be refinanced upon completion of the ADU renovation and combined with your primary mortgage

Second Mortgage Or Fixed Home Equity Loan

A second mortgage or fixed home equity loan

  • Is based on the amount of equity you have in your home
  • Is a single loan for a fixed amount (unlike a HELOC that allows you to borrow and repay as needed up to the limit of your loan)
  • Has a higher interest rate than a mortgage
  • Usually has a fixed interest rate
  • Will usually have repayment periods of 10-30 years
  • Will charge closing costs and fees when taking out the loan, similar to a first mortgage

Cash-Out Refinance

A cash-out refinance

  • Replaces your current mortgage
  • Allows you to borrow a higher amount than your original mortgage based on the current equity of your home (because you have been making payments on your mortgage and/or your home has appreciated in value)
  • Requires a portion of the loan amount to pay off the original mortgage, so the only cash you can qualify to receive will be the higher equity in your home
  • Can be fixed or variable interest rates
  • Can be 10-30 years in length
  • Will charge the closing costs and fees usually associated with applying for a new mortgage
  • Will usually have the lowest interest rates of all the loan types discussed in this article

Other Sources Of Financing For An ADU

The traditional types of loans discussed above are not the only sources of financing available to you if you want to build or create an ADU on your property. Other options include:

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Unsecured credit – think credit cards

  • You’ll pay significantly higher interest rates on these types of loans
  • You will probably damage your credit by having multiple cards showing high balances
  • Probably are only a good idea to use for initial costs, like architectural drawings before getting a traditional loan

Friends And Family Loans

Got a rich uncle who loves you enough to give you a loan for an ADU? Now may be the time to call him.

Retirement Account Loan

  • Some retirement accounts allow you to take a loan against the funds in that account to pay for home improvements
  • While this is probably a bad idea, you may consider it based on the increased value in your home
  • You will want to repay that loan so you can retire!
  • You’ll usually be limited to some percentage of the retirement account assets, like 50%

Is An ADU Right For You?

It may be, depending on your current financial situation, the equity you have in your existing house, the rent conditions in your local market, and your willingness to put up with the hassle of having someone else living on your property. Plus, ADUs can bring in healthy cash flows and increase the value of your house.

Have Questions About Qualifying for a Mortgage?

We can help! You can Ask Your Question here and we will connect you with a Mortgage Expert in your area that can help, or you can find a Mortgage Expert Near You below this article.

About the Author

Scott Schang

A 20+ year veteran of the Mortgage and Real Estate industry, I am passionate about educating and empowering consumers. I have been writing about consumer protection issues and making sense of complicated real estate and mortgage topics on this website since 2007

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