ADUs are a great way to increase the value of your property and create some extra income, but financing can be tricky. There are a lot of options out there when it comes to financing an ADU. It can be hard to know which one is right for you. We’ve put together a list of the three most common ways to finance your ADU. Let’s discuss and try to simplify each one and see which best fits you.
1. Home Equity Line of Credit (HELOC)
A HELOC is a loan that uses your home as collateral. The lender will approve you for a certain amount, and then you can borrow money as needed. The amount you can borrow depends on how much your home is worth and how much you still owe on your mortgage. HELOCs often don’t have any fees, which makes them a good option.
Primary residences can borrow up to 80-90% of their Loan-to-Value amount or latest property value. Your interest rate will be higher than a traditional mortgage, but the terms (10 years for example) are fixed. You can also refinance after construction is complete to combine it with your primary mortgage.
Here’s a simplified example. You have a property that is appraised at $800,000 while your current mortgage is at $500,000. We’ll take 80% of the latest estimate of property value and subtract the amount to your existing mortage. The difference you get would then be your Line of Credit for your ADU. If we put in in an equation, it’ll look like this:
Variables:
80% Granted Percentage of Lender
$800,000 Property Appraisal
$500,000 Remaining Mortgage
Equation:
800,000 x 0.8 = 640,000
640,000 – 500,000 = 140,000
Line of Credit = $140,000
2. Cash-Out Refinance
If you have equity in your house, you can use it to get a cash-out refinance. A cash-out refinance is when you get a new mortgage to pay off your old one and also get extra cash. This means that you replace your current mortgage with a new loan for more money than you owe on your house. The extra money will be given to you in cash, which you can use for building an ADU or doing other renovations.
These loans usually have a fixed rate and last for 30 years. There are closing costs associated with a refinance, but they are rolled into the new loan amount and don’t have to be paid out of pocket. The benefit of a refinance is that the principal and interest payment will remain constant over the life of the loan. Most cash out refinances can typically range around 80%-90% of the appraised value of your home.
Here’s a simplified example. You have a property that is appraised at $800,000 while your current mortgage is at $500,000. This means that you have $500,000 of the loan remaining and $300,000 of equity value in the property. In this method, you can convert some of that equity into cash. This means that they take out a new mortgage for more than the old one – in this case $640,000. You then get $140,000 in cash and the rest is put back into the property.
Variables:
80% Granted Percentage of Lender
$800,000 Property Appraisal
$500,000 Current Mortgage
Equation:
800,000 x 0.8 = 640,000
640,000 – 500,000 = 140,000
Cash = $140,000 minus the additional closing costs
3. Home Construction/Renovation Loans
Home renovation loans are based on how much your home will be worth after the renovation. The loan uses the estimated value of your home after the renovation to calculate how much money you can borrow. This gives you credit for the increase in your home’s value that will come from the proposed renovation.
This can be a good alternative for homeowners who do not have 20% equity in their home, and need to cover construction expenses. By using the appraised value of the property once the ADU is completed, the owner then might have enough equity to qualify for the loan.
Here’s a simplified example. You have a property that is appraised at $800,000 while your current mortgage is at $500,000. For traditional home equity loans, the usual rule is that you can borrow up to 80% of the current value of your home. So when using the latest appraisal of $800,000, the 80% value of it would be $640,000 reduced then by your current mortgage of $500,000, leaving $140,000 left for you.
With construction loans, instead of using the current appraisal of your property, these products use the future value of your home or when the renovation (ADU) is finished. In this case, from your home’s current value of $800,000, it has the potential to reach $1,000,000 after the ADU construction is completed.
With this on hand, 80% of $1,000,000 is $800,000 minus your remaining mortgage of $500,000 – leaving you with $300,000 to use.
Variables:
80% Granted Percentage of Lender
$800,000 Property Appraisal
$500,000 Current Mortgage
Traditional Loan:
800,000 x 0.8 = 640,000
640,000 – 500,000 = 140,000
Line of Credit = $140,000
Construction Loan:
80% Granted Percentage of Lender
$800,000 Future Property Appraisal
$500,000 Current Mortgage
1,000,000 x 0.8 = 800,000
800,000 – 500,000 = 300,000
Line of Credit = $300,000
Here are the 3 usual types of Construction/Renovation Loans:
- Single-Close Construction To Permanent Loan (CTP). This loan converts to a new permanent mortgage after your home is renovated. It’s like a cash-out refinance, but based on the value of your home after it is renovated. This construction loan requires the bank or the lender to pay the contractor and not the homeowner – through a milestone-based disbursement schedule that requires onsite inspections.
- Fannie Mae HomeStyle Loan. This is a mortgage that people can use to finance the costs of renovating their homes. Fannie Mae is a government-sponsored enterprise that buys mortgages from banks. Banks can then use the money to make more mortgages. This keeps the economy going by keeping banks liquid. Though Fannie Mae is not a lender, its interest rates are low. This, however, is different from a regular loan. With this loan, the money is given to you when you close on the house. But in order to use the money to fix up your house, you need to have a contractor approved by the bank. The contractor can then get paid in stages after they show that the work was done properly. Read more: FannieMae FAQs
- Federal Housing Association 203k (FHA 203K) Loans. These are very similar to Fannie Mae Homestyle Loans. The only difference is that it is insured by the FHA, also a government-sponsored agency, and not Fannie Mae. A 203(k) loan is a type of mortgage which lets people finance the cost of their home and the cost of any repairs that need to be done at the same time. This is a loan where you get one mortgage for the cost of the property and the renovations. Though this affiliation has some advantages like lower credit score requirements, it tends to also have higher rates. Read more: FHA 203k – HUD
Conclusion
There are a few ways that homeowners can finance the construction of an accessory dwelling unit (ADU). One way is by using their home equity. Another way is by using their income, savings, and creditworthiness. However, not all homeowners have enough money to pay beyond a $200,000 project on their own. Low and moderate-income homeowners can sometimes qualify for traditional mortgage products, but there is often a gap between the cost of constructing an ADU and what they are able to borrow.
ADU.Works strives to find ways to help homeowners in California find ADU products that can be built for almost half the time and cost of an average model. Through the use of innovative and efficient processes, we are able to offer high-quality, reliable, and attractive ADUs that only have a starting cost ranging from $139,400 – 182,400 with no hidden costs. Whether you’re looking for a 1B, 1BTH, a 2BD 1 BTH, or a 2BD 2BTH, ADU.Works wants to help you build your new ADU.
If you’re interested, please don’t hesitate to book a consultation with us or give us a quick call through our number (408) 610 3005. We’ll gladly discuss the specifications of the Maverick Models and accommodate any questions you may have. Our team looks forward to hearing from you.