Financing your ADU

A cash-out refinance lets you replace your current mortgage with a new, larger one, giving you cash upfront that you can use to build an Accessory Dwelling Unit (ADU) like a guest house or small apartment on your property. After your ADU is complete, you might refinance again to get a better interest rate based on your home's increased value.

This method is popular for funding ADUs, especially if you’ve built up enough equity in your home. To qualify, you need enough equity to cover the amount you want to borrow plus a little extra. One big advantage is that cash-out refinances usually come with lower fees than other loan options. However, you get all the cash at once when you close the loan, so it’s important to stick to your budget to avoid overspending.

You can choose between fixed-rate loans, which keep your payments steady, or adjustable-rate loans, where payments can change over time. Banks and mortgage brokers can guide you through the process.

Pros:

• You have full control over how to use the funds for your project.
• Interest rates are generally lower than construction loans or other credit types.
• You’re making the most of your home’s value.
• There are no restrictions on how you use the ADU.

Cons:

• You need to carefully manage your budget since you usually can’t get more money later.
• The process can take time and effort, especially if you refinance again after construction.
• There are fees involved, which can be added to your loan but still cost you money.

A home equity loan, or second mortgage, is an extra loan you take out on your home while you still have your original mortgage. It’s called a "second" mortgage because it comes after your first one. You can get this loan from a bank or mortgage broker, and you’ll be responsible for paying both loans at the same time. While some people think a Home Equity Line of Credit (HELOC) is a second mortgage, this part of the guide focuses on a traditional second mortgage where you get a lump sum of money.

You can get a second mortgage from the same lender as your first mortgage or from a different one. Many homeowners shop around to find the best deal. Because this loan is a bit riskier for lenders, the interest rate is usually a little higher than your first mortgage. Sometimes, you might need permission from your first lender before getting a second mortgage. You’ll also need enough equity in your home — meaning your home’s value minus what you owe — to cover this new loan and a little extra.

Pros:

• If your first mortgage has a low fixed interest rate, a second mortgage might be better than refinancing your first one.
• The fees for a second mortgage can sometimes be lower than refinancing fees.
• You can lock in a fixed interest rate, protecting you from rising costs later.
• The money you get is flexible and can be used for many purposes.

Cons:

• If your first mortgage has a high interest rate, refinancing might be a smarter choice.
• If you don’t need the money right away, a HELOC might be cheaper because you only borrow and pay interest when you need funds.
• You’ll likely start paying the second mortgage while still working on your renovations, unless you combine it with other financing.

A Home Equity Line of Credit, or HELOC, is a loan that lets you borrow money based on how much of your home you own outright (your equity). If you have some equity built up, you can borrow a certain amount to help pay for your accessory dwelling unit (ADU).

One great thing about a HELOC is that you only pay interest on the money you actually use. So, you can wait to borrow money until you need to pay your builder for the ADU work.

HELOCs are popular for financing ADUs if you have enough equity in your home. It’s smart to keep a little extra equity as a safety net. While HELOC interest rates are usually low, it’s still good to check other options like refinancing your mortgage, which might offer even better rates.

Pros:

• You control how and when to use the money for your ADU.
• Interest rates are often lower than other loans, like construction loans.
• You only pay interest on the amount you borrow.
• You can borrow just what you need, no more.

Cons:

• You need to stick to your budget because it can be hard to get more money if costs go up.
• You’ll have two payments each month: your regular mortgage and the HELOC. Later, you might want to refinance to simplify payments once your ADU is done and your home value goes up.
• HELOCs can also be used for other things like emergencies or education, so if you’re using it for your ADU, it’s good to have other savings for those needs.
• Many HELOCs have variable interest rates, which means your payments could go up if rates rise.

Home equity investments (HEI), also known as home equity sharing, offer an alternative way to finance building an Accessory Dwelling Unit (ADU) without taking on traditional debt. With an HEI, a homeowner partners with an investor who provides cash upfront in exchange for a share of the home's future appreciation. Unlike a loan, there are no monthly payments or interest charges; instead, the investor receives a percentage of the home's increased value when the property is sold or after a set period.

This option can be attractive for homeowners who want to access funds for ADU construction but prefer to avoid additional monthly debt obligations. However, it’s important to understand that sharing future equity means giving up a portion of any potential gains, so careful consideration and consultation with financial advisors are recommended before choosing this financing method.

Pros:

• No monthly loan payments or interest charges.
• Access to cash upfront without increasing monthly debt.
• Can be a good option for homeowners with limited borrowing capacity.
• Investor shares the risk of property value fluctuations.

Cons:

• You give up a portion of your home's future appreciation.
• The total repayment amount can be unpredictable depending on market conditions.
• Agreements can be complex and may have long terms.
• Not all investors or programs are widely available; may have limited options.

A reverse mortgage is a special loan for homeowners aged 62 and older. It lets you borrow money using the equity in your home without having to make monthly payments. Instead, the loan is usually paid back when you sell your home or after you pass away. This can be helpful if you want some extra cash now, but it might not be the best choice if you want to leave your home to your heirs, since the debt can grow over time.

To qualify, you need to have enough equity in your home to cover any existing mortgage. Your age also matters—older homeowners usually qualify more easily. Plus, you’ll need to show you can pay property taxes and any homeowner fees.

Unlike regular mortgages where you pay down your loan over time, a reverse mortgage lets the debt build up, and you can get the money as a lump sum, monthly payments, or a line of credit. Many people like the line of credit option because it gives flexibility to use the money when needed and even pay down the balance to reduce interest.

Pros:

• No income requirements to qualify.
• You can stay in your home for life.
• Good if you don’t plan to leave the home to heirs.
• Can provide extra income, especially if you rent out an ADU.

Cons:

• Not ideal if you want to pass your home to family.
• Interest rates are usually higher than other loans like HELOCs.
• Debt can grow quickly due to compounding interest.
• Family moving in after you pass may face eviction risks.
• Be careful of scams targeting seniors.
• Moving to a care facility could force you to sell the home.You can get a second mortgage from the same lender as your first mortgage or from a different one. Many homeowners shop around to find the best deal. Because this loan is a bit riskier for lenders, the interest rate is usually a little higher than your first mortgage. Sometimes, you might need permission from your first lender before getting a second mortgage. You’ll also need enough equity in your home — meaning your home’s value minus what you owe — to cover this new loan and a little extra.You can get a second mortgage from the same lender as your first mortgage or from a different one. Many homeowners shop around to find the best deal. Because this loan is a bit riskier for lenders, the interest rate is usually a little higher than your first mortgage. Sometimes, you might need permission from your first lender before getting a second mortgage. You’ll also need enough equity in your home — meaning your home’s value minus what you owe — to cover this new loan and a little extra.
• Loan payments might affect Medicaid eligibility.

Using your own cash and resources is a common way for homeowners to pay for part or all of their Accessory Dwelling Unit (ADU) costs. Building an ADU can be a smart investment, and using your savings instead of loans can save you time and avoid extra hassle.

Pros:

• Paying with money you already have means you don’t need to take on debt.
• An ADU can be a good investment and may bring in extra income.
• Avoiding or reducing loans can help protect your credit score.
• Some people might not qualify for loans, so using savings is a good alternative.

Cons:

• Sometimes, other investments like stocks might earn you more money than building an ADU.
• It’s important to work with your project team to set a realistic budget and make sure you have enough funds.
• Some loan options made just for ADUs might offer better rates, so it’s worth checking them out.

Some people think about borrowing money from their 401(k) retirement account to help pay for building an accessory dwelling unit (ADU). However, not every employer allows this. If your employer does, you can usually borrow up to $50,000 or half of your 401(k) balance, whichever is less, within a year.

Taking a loan from your 401(k) works like a regular bank loan. You’ll repay it in regular payments over time, and you’ll also pay interest on the amount you borrow. The good news is that when you pay back the loan, both the money and the interest go back into your 401(k).

Keep in mind, you can only take out a 401(k) loan if you have enough money saved and if your employer allows it. If you repay on time, you avoid penalties, unlike an early withdrawal. But if you don’t repay the loan within the set time (usually five years), the remaining amount might be taxed as income.

These loans are managed by the company that handles your retirement account. Before deciding, it’s a good idea to think about how borrowing might affect your retirement savings. Talking with a financial advisor can help you understand the pros and cons.

Pros:

• You’re basically borrowing from yourself, so no outside lender charges you interest.
• Usually no minimum credit score is needed, and it won’t affect your credit report.
• If you repay on time, it can be cheaper than taking money out early.

Cons:

• You might pay interest to your own account, or your investments might lose value while the loan is outstanding.
• Repayment periods are often short, usually five years.
• You have to start paying back the loan while your ADU is still being built, so you need funds to cover payments before rental income starts.
• If you don’t repay, you could face taxes and penalties.
• If you leave your job, you may have to repay the full loan quickly.
• There may be fees involved.

Private money, also called a bridge loan, is a short-term loan that usually has an interest rate between 6% and 12%, depending on your situation. Many homeowners use private money loans to pay for construction projects, planning to refinance once the building is done. This way, the private loan gets paid off quickly.

Unlike traditional construction loans from banks, private money comes from private investors. Recently, interest rates have dropped, and faster building methods like modular or prefab construction have made private money loans more attractive for some people.

Private money loans aren’t for everyone, but they can be helpful in certain cases. Private lenders are often more flexible about new construction methods than traditional banks. You can get these loans through mortgage brokers or specialized lenders. Usually, you need to offer some kind of collateral, like property, to secure the loan.

Pros:

• You have full control over your project funds.
• If the property is an investment, payments might be interest-only and could be tax-deductible.
• The loan process is usually quicker and requires less paperwork.
• Private money works well for unique situations or special borrower needs.
• You can sometimes use one property as security to finance construction on another if your building site doesn’t have enough equity.

Cons:

• Interest rates are often higher than traditional loans like refinancing, second mortgages, or HELOCs.
• You need to carefully watch your budget because it can be hard to get more money later if needed.
• You’ll likely have two monthly payments: your current mortgage and the private loan. Eventually, you’ll need to refinance to pay off the private loan once construction is finished.

Private money, also called a bridge loan, is a short-term loan that usually has an interest rate between 6% and 12%, depending on your situation. Many homeowners use private money loans to pay for construction projects, planning to refinance once the building is done. This way, the private loan gets paid off quickly.

Unlike traditional construction loans from banks, private money comes from private investors. Recently, interest rates have dropped, and faster building methods like modular or prefab construction have made private money loans more attractive for some people.

Private money loans aren’t for everyone, but they can be helpful in certain cases. Private lenders are often more flexible about new construction methods than traditional banks. You can get these loans through mortgage brokers or specialized lenders. Usually, you need to offer some kind of collateral, like property, to secure the loan.

Pros:

• You have full control over your project funds.
• If the property is an investment, payments might be interest-only and could be tax-deductible.
• The loan process is usually quicker and requires less paperwork.
• Private money works well for unique situations or special borrower needs.
• You can sometimes use one property as security to finance construction on another if your building site doesn’t have enough equity.

Cons:

• Interest rates are often higher than traditional loans like refinancing, second mortgages, or HELOCs.
• You need to carefully watch your budget because it can be hard to get more money later if needed.
• You’ll likely have two monthly payments: your current mortgage and the private loan. Eventually, you’ll need to refinance to pay off the private loan once construction is finished.

Construction loans are short-term loans that help you pay for building a new structure or expanding your current home. Unlike regular home loans, which are based on your home's current value, construction loans focus on what your home will be worth after the work is done. To get one, you'll usually need to show a detailed plan, have an appraisal proving the new construction adds value, and be able to cover interest payments during the build.

There are three main types of construction loans:

1. Construction-to-permanent loans: These are great if you have clear plans and a timeline. The lender pays your builder as work progresses. When the project is finished, the loan turns into a regular mortgage, letting you lock in your interest rate early for steady payments.
2. Construction-only loans: These loans cover just the building phase and must be paid off once construction is done. They're good if you have cash saved or plan to sell your current home to pay off the loan. Afterward, you'll need another loan if you want a mortgage on the new place.
3. Renovation construction loans: If you're buying a home that needs major repairs or want to build an ADU, this loan covers both the purchase and renovation costs. Some government programs support these loans. For example, Housing Trust Silicon Valley offers a construction-to-permanent loan for homeowners building ADUs, which can be great for housing family members like aging parents or adult children while creating affordable housing options.

Pros:

• These loans consider your home's future value, which can make qualifying easier.
• Some lenders offer special loans for building ADUs, like in-law suites or garage apartments.
• You can choose a loan that converts to a mortgage after construction or a short-term loan you refinance later.
• Funds are often held in an escrow account and released as work is completed, ensuring your builder finishes the job before getting paid.

Cons:

• Interest rates are usually higher than regular mortgages.
• You must complete construction within a set time.
• Short-term loans can be risky if you don’t have a plan to pay them off or refinance afterward.
• Appraisals sometimes undervalue ADUs, especially if converting existing spaces, which might make qualifying harder.

A renovation loan is a type of mortgage that helps you buy a home and pay for repairs or upgrades all in one loan. If you want to buy a house and build an accessory dwelling unit (ADU), this loan can cover both costs together.

There are two popular renovation loans: the 203(k) loan from the Federal Housing Administration (FHA) and the HomeStyle® loan from Fannie Mae. You don’t get these loans directly from the FHA or Fannie Mae—they are offered by banks or mortgage brokers. Not every lender offers these loans, so it’s a good idea to shop around.

Here’s a quick look at the differences:

203(k) Loan:

• Easier credit score requirements.
• You must live in either the main house or the ADU.
• It’s not always clear if you can use it for a detached ADU.
• Construction needs to be finished within six months.

HomeStyle® Loan:

• Usually requires a better credit score.
• Can be used for any ADU, including rental or vacation homes.
• Gives you twelve months to complete construction.
• May have lower mortgage insurance costs if you have good credit.

Both loans have limits on how much you can borrow, which depend on where you live. For example, in 2024, the max loan for a single-family home is $1,209,750 in expensive areas and $524,225 in less costly areas. Check the latest limits for your county online.

Pros:

• Buy a home and build an ADU with just one loan.
• 203(k) loans are more flexible if your credit isn’t perfect.
• Both loans let you borrow a high percentage of your home’s value—sometimes up to 110% of what your home will be worth after the work is done.
• Having a clear budget and timeline helps keep your project on track.

Cons:

• Interest rates might be higher than regular mortgages.
• You need to hire a licensed contractor, so it’s not ideal if you want to do the work yourself.
• There are strict deadlines and loan limits, so you need a solid plan to finish on time and within budget.
• The paperwork can be more complicated and take longer to close than a standard mortgage.
• If your lender isn’t experienced with renovation loans, it could cause delays—so ask for references before choosing one.

A ground lease is a way to finance an accessory dwelling unit (ADU) where the builder pays for the construction instead of the homeowner. In this setup, the builder finds a tenant (with the homeowner’s approval) and collects rent from them. The homeowner benefits by receiving a small share of the rent each month and, after the lease ends—usually between 15 and 25 years—the ADU often becomes theirs at no extra cost.

Right now, only a few builders offer ground leases, mostly for new detached ADUs built in backyards. This option might depend on your location, your current mortgage, and how much equity you have in your home.

Here are some pros:

• You can earn monthly income without paying upfront or taking on debt.
• The builder handles the entire construction, making it easier for you.
• When the lease ends, the ADU usually becomes yours without extra fees (but check with the builder to be sure).
• The builder designs the ADU to be profitable.
• The builder manages tenants and rental issues, so you don’t have to.
• This option is great if you don’t have enough income to refinance but want to start earning rental income.

And some cons:

• If a family member lives in the ADU, they still need to pay rent.
• Since this is a newer financing method, there aren’t many government rules, so read the contract carefully and understand what happens if the builder runs into trouble.
• The builder controls the design, so you might have less say.
• Sometimes, financing the construction yourself and collecting rent directly could earn you more money.
• For very long leases (35 years or more), you may want to talk to a tax expert about possible property tax changes. Shorter leases usually don’t cause this.
• Some current mortgages might not allow ground leases, so check your loan terms.

Here are some less common ways to help pay for building your Accessory Dwelling Unit (ADU). While these might not cover all the costs on their own, they can be useful parts of your overall financing plan:

1. Borrowing from Friends or Family: This is a popular choice, especially if someone close to you will live in the ADU. It's a good idea to write down the loan details to avoid any confusion later. There are services that can help manage the paperwork and payments to keep things clear and friendly.
2. Personal Loans: These loans come from banks and are based on your income and credit score, not your home. To qualify, you usually need a steady income and a good credit history.
3. Credit Cards: Using credit cards can give you quick access to money, but the interest rates are often high, so it’s best to avoid this unless you have no other choice. Also, many contractors don’t accept credit cards, so you might end up taking cash advances, which can add extra fees.
4. Local Government and Nonprofit Programs: Some cities and nonprofit groups offer special financing to help homeowners, especially those with lower incomes, afford an ADU. Check online or contact your local planning office to see if there are programs near you.