How to Determine Your ADU Financing Options
There are several different ways to fund your ADU project. Read on to learn more about what might be best for you.
Financing an accessory dwelling unit (ADU) isn't always easy. Unless you have enough cash, home equity, or loans from friends or family, you may have a tough time figuring out how to acquire the funds for your project.
Housable surveyed California homeowners considering building an ADU and found that financing was the #1 obstacle to moving forward on a project.
If you are having more trouble than you expected in financing your project, you are probably wondering why. There may be a simple explanation: most lending and financial institutions don't have the right processes to facilitate ADU financing.
If you think about most consumer lending and single-family housing, credit is structured around a 15 or 30-year mortgage with the expectation that the homeowner is going to live in the house and will pay it back over time. The home may appreciate if the market goes up, but there is no additional passive income for a single-family dwelling.
Accessory dwelling units, on the other hand, are often built to rent out and generate passive income. This approach means that the payback periods are shorter, which in theory should make it easier to get financed.
To more clearly illustrate this point, think about the difference between buying a car and a solar panel. As soon as you purchase the vehicle, it decreases in value and continues to decrease over time. On the other hand, as soon as you install a solar panel on your roof, it starts generating value through electricity, which allows you to save money or sell back to the grid.
An ADU is like a solar panel in that regard.
Unfortunately, most banks aren't familiar with the ADU model and haven't developed financial products to serve this market. Subsequently, many families who should be getting financed unfortunately aren't.
Things are changing fast. ADUs are starting to get popular across the state of California, and some forward-thinking lenders are beginning to get in on the action.
The website AccesoryDwellings.org called 2019 The Year of ADU Financing Innovation, writing that organizations across the country are experimenting with different strategies to finance ADUs.
This article gives you a sense of where the ADU lending market has been, where it is going, and perhaps give you some new ideas of how you could potentially finance your project.
How ADU Financing Has Functioned In the Past
Before we dig into the more experimental financing strategies emerging on the market, let's look at where most of the market has been in the past.
Cash is king, as they say. A lot of ADUs were built in affluent areas because homeowners could afford to move forward without dealing with the lending intricacies. A certain percentage of people paid for their ADU entirely with cash.
Cash is always the easiest way to finance your ADU project, and it simplifies everything. If you're able to do this, kudos to you.
On the other hand, some homeowners financed their projects with a blend of cash and loans later on. They covered the design and permitting costs, which allowed them to get an estimate before they got financed.
Are you interested in designing an ADU for an affordable price? Learn how you can by searching your property address
Paying in cash is also a smart decision because it allows the homeowner to gather relevant information before taking on a loan. The more you can accomplish with cash, the better, and the lower the loan will be later on.
Retirement Withdrawal and Loans
Many retirement accounts allow you to borrow against up to 50% of your balance, with a limit of $50,000. These are low-cost loans and shielded from taxes. If you have a sufficient amount of money in your account, this might be a good option to partially finance your project.
If you are approaching retirement and old enough to take money out without penalty, this may be a great opportunity to finance your project. Remember, you were saving all of these years to fund your lifestyle after you stop working! An ADU is an affordable housing option, and by building one, you can retire in your backyard, rent-free.
If you can take a low interest or interest-free loan from loved ones, this may be a great strategy to get your project completed. But remember, if this is a short term loan, make sure you have a clear plan in place to repay or risk negatively affecting your relationships.
Many people have financed their ADU projects with credit cards; we do not recommend this strategy. Increasing your credit card balance will hurt your credit score, and you will be responsible for paying the interest. Don't use a credit card unless you can quickly pay it back.
The amount of equity that you have in your current home is the most critical determinant of whether you will be able to get financed for your ADU project. If you bought your home a long time ago and have paid off a significant amount of the balance on your mortgage, you will be able to use this to your advantage.
Your options include:
A HELOC or a HELoan is a second loan in addition to the mortgage that you already have. The two loans have different structures and repayment terms - the rate of your existing mortgage does not need to change.
HELOCs are very popular and relatively straightforward to setup. You can borrow a very high percentage of your property's current value, often as much as 90%. They work as lines of credit, which means that the funds are available to you, but you can use them when you are ready: you don't pay interest until the funds go to use.
If your credit line limit is $250,000, but you've only used $40,000 to date, you are only paying interest on the lower amount.
The disadvantage of HELOCs is that they are almost always structured with a variable interest rate pegged to prime market interest rates. If interest rates increase, you may see your initially attractive rate skyrocket to a much less exciting rate. Thus, HELOCs come with risk, and you should be mindful of your ability to repay the interest and the balance withdrawn.
HELoans, on the other hand, are fixed-rate second mortgages. Your payment won't go up, but you are paying interest on the entire balance from the beginning. These loans are structured over a shorter period than a typical mortgage (5-15), and have a higher interest rate as well.
Many HELOCs can convert to HELoan over time.
Ask your lender about HELOCs and HELoans to get a sense of whether either one would make sense for you.
Another option to make your equity work for you is to refinance your existing mortgage into a brand new one.
You have many options when you refinance; the rates are lower than HELOC/HELoan, and you can choose between a fixed or adjustable rate. You can also choose the mortgage term that makes the most sense for you.
Two disadvantages of refinancing are the closing cost and the possibility of giving up a low rate on your first mortgage. Closing costs for refinancing are as high as $5000, whereas many HELOCs don't even have closing costs.
Also, if you want to refinance but you had a better rate on the first mortgage, you will be paying a higher monthly interest payment on this larger refinanced mortgage.
If you don't have a pile of cash and lack the equity necessary for HELOCs and refinancing, the next option is construction loans.
Construction loans give you the ability to borrow from the future value of your project after completion.
Construction loans generally finance single-family residences, but they are also a potential solution for ADU construction.
Your lender finances your project with an understanding of the different phases. You only pay interest during construction, and then you repay the balance once the project is completed (generally fixed rate over a thirty-year period).
Renovation loans are typically structured as a refinancing.
It is essential to recognize that the lender of a construction loan is an expert in this area, and will want to know all of the details of your project, including who will be building it. He/she will also monitor the construction process.
The lender of construction loans is interested in understanding what the value of the project will be when it is completed. You need to provide as much information as possible about the ADU project, including your design concepts, permit set, and contractor bids. You will also need to present an appraisal document projecting the market value for the completed project.
You must decide on a certified contractor with a fixed price for your project to close.
Once the financing closes, your project can launch, and the lender will hold the funds until it is time to disperse. The lender will come to the project site to review the project and write a check.
Closing costs on construction loans are very high, but the advantage is that these loans are reviewed and structured by experts who may be more likely to issue you credit based on their knowledge of the field.
Renovation loans are similar to Construction loans but have some crucial differences, which may work to your advantage.
The advantage of the renovation loan is that you are provided with some extra capital to manage the potential variable costs of the project (between 10-20% of total construction costs). You will be required to pay off the monthly balance right from the beginning (as opposed to the flex period offered by construction loans).
The crucial difference between a renovation and construction loan is that a renovation loan can close before the ADU permit has been issued. Renovation loans close very fast, as little as thirty days after you order your appraisal. All you need to get financed are design concepts, a bid from a contractor, and the appraiser report.
New Financing Options
Now that we've reviewed the historical ADU financing solutions let's get a little more experimental. There's plenty of action on the markets, sometimes too much.
Here are some exciting solutions for ADU financing:
Community Development Financial Institutions (CDFI)
CDFIs are private institutions that have the stated goal of helping lower-income communities climb up the economic ladder. They provide responsible lending and affordable rates to communities in need.
CDFIs are either for-profit or nonprofit, depending on the institution.
They regularly provide financing to small businesses, nonprofits, and affordable housing projects in distressed communities.
CDFIs have gotten involved in ADU financing because they recognize that ADUs are an essential solution to providing affordable housing.
The Housing Trust of Silicon Valley, a nonprofit CDFI, launched a pilot program called Small Homes, Big Impact. This pilot offers educational workshops around building an ADU and will provide financial assistance (in the form of a construction bridge loan up to $250,000 at 5% interest) to homeowners looking to build an ADU.
Insert Link Like thisContact the Housing Trust for more information on this CDFI's program.
Government Grants and Loans
Most California municipalities are still grappling with the change in the state laws, which legalized ADUs everywhere. They barely know how to handle the regulations, forget financing options.
However, faster-moving cities are looking into lending opportunities to boost housing stock.
Free money and grants from the government are always ideal. However, a low-interest interest or free loan is an attractive option as well.
The City of San Jose is exploring a program that will offer 5 million dollars in loans (up to $20,000 per homeowner) to qualifying homeowners looking to build an ADU.
Call your city planning office and ask if they have any ADU loan or grant program.
For-Profit Vendor Financing
There is a range of vendors on the market who will finance your ADU for you and own the building until you pay it back over a given time frame.
Companies like United Dwelling will finance the entire ADU project and build it for you, and then act as a property manager for the ADU once it is completed. The customer then pays the ADU back over time, partly financed through rental income.
Keep in mind that this reduces the amount of flexibility you have in what you can do with the project (it wouldn't work if you need it for your own living space). These companies will also manage the property for you, which means that you are working with a third party for an extended period of time.
Peer to Peer (P2P) Financing
P2P has grown significantly in all sectors of home construction financing. For more information, please check out this articlewhich goes into more detail.
The ADU Market is still quite small. As a result, Government-sponsored entities like Fannie Mae do not currently support ADU loan purchasing, which limits the market from growing into something much bigger.
As the ADU market grows nationwide, we should expect to see significant changes that make it much easier to get financed. It will be easier to appraise and value ADUs, which should result in reductions in closing costs as well.
In the meantime, find out if you are eligible to add an ADU on your property by searching your city and address at Housable.comThe above does not constitute financial advice. Please get in touch with your certified lender for a professional opinion regarding your specific financial options. Research cited from Workshop Mortgage.