The 5 Best Ways to Finance an ADU – Plus Alternatives to HELOCs

Everyone on your street is putting an ADU in their backyard and talking about all this rental income they are making.

I bet you want a piece of the action.

Maybe you are overwhelmed by the complex financial landscape that surrounds it. If so, you’ve landed on the perfect article.

There are some well-known ADU financing options like the HELOC and renovation loan, but some new options were born from the rise in ADU popularity.

Who are the new players on the block?

You get to meet the Home Equity Investment and Rent-Sharing Loans as part of the best ways to finance an ADU.

Your financial path to a new ADU starts here!

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What are the 5 best ways to finance an ADU?

There is more than just HELOCs to finance your ADU. Thanks to the rise in ADU options and players like Boxabl advertising affordable backyard options, the demand has grown for some new products.

While HELOCs are popular, a few new products have hit the market. The 5 best ways to finance an ADU are:

• Home Equity Investment
• ADU rent-sharing loans
• Cash-out refinancing
• Home’s equity line of credit (HELOC)
• Renovation loan

Each has advantages, limitations, fees, whether equity is used, and credit score requirements, which we will explore.

The two newer options you may not have heard of are Home equity investment and ADU Rent-Sharing Loans.

Rent-Sharing Loans and Home Equity Investments were born out of a need for more options for ADU financing.

1. Home Equity Investment

Overview

A Home Equity Investment (HEI) allows homeowners to access up to 25% of their home’s equity in exchange for a share of their property’s future appreciation or increased property value.

Companies like Point, Hometap, Unlock, Splitero, and Unison offer this type of investment, requiring no debt to be taken on by the homeowner.

Pros

• Debt-Free Financing: Unlike traditional loans, HEIs do not require you to take on debt, so you are saving money.
• No Monthly Payments: No monthly payments are involved, easing homeowners’ financial burden and one of the huge financial benefits.
• Broad Eligibility: Approval is not based on household income, debt-to-income ratios, or credit scores but on the potential future value of the home.
• Availability of Funds: The swift approval process quickly makes funds available for your project.

Cons

• Non-Negotiable Appraisal: The investor’s appraisal of the property value is final and cannot be negotiated.
• Time-Bound Buyout: The investor must be paid off within a set timeframe (usually between 10 to 30 years), either through a refinance, a buyout, or selling the home.

Summary

Home Equity Investments (HEIs) are an innovative and debt-free way to finance an ADU many homeowners take advantage of.

They offer quick access to cash without monthly payments and are open to a broader range of homeowners based on the future home’s equity rather than traditional credit metrics.

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2. ADU Rent-Sharing Loans

Overview:

Rent-Sharing Loans (RSL) is a unique financing option that mixes construction and fixed-rate loans. These loans allow for payment flexibility and various contingencies.

Pros:

• Flexibility: Flexible repayment options.
• Deferred payments: No payments are required for up to two years.

Cons:

• Complex paperwork: Complex agreement terms may be difficult to navigate.
• Fewer options: Fewer vendors are offering this option.

Summary:

Rent-Sharing Loans offer a unique and flexible way to finance an ADU project.

These loans come with various features designed to ease the financial burden on homeowners.

3. Cash-out refinancing

Overview

A cash-out refinance involves refinancing your current mortgage and releasing some of the built-up home equity to finance the construction of your ADU.

This approach consolidates the funds needed for your ADU and primary mortgage into one single loan or as a second mortgage.

Pros

• Simplifies Payments: By consolidating the ADU construction loan and your first mortgage, you will have only one monthly payment to manage.
• Use of Home Equity: It allows you to leverage the equity you’ve built in your home, practically making those funds work for you like constructing an ADU.

Cons

• Limited Borrowing Capacity: Most cash-out refinance options restrict you to borrowing up to 80% of your home’s value.
• No Incremental Borrowing: Unlike a home equity line of credit, you get a lump sum instead of the flexibility to borrow as needed.
• More Debt: Since payment is due on this loan option, the extra income you earn from the accessory dwelling unit will be reduced.

Summary

Cash-out refinances can be a great way to finance an ADU if you have enough home equity and want the convenience of a single, consolidated loan. Plus, the potential for lower interest rates makes it even more appealing.

Just remember the limitations on borrowing and the risk of taking on more debt.

4. Home Equity Line of Credit (HELOC)

How It Works

Getting a HELOC for your ADU is the most well-known ADU financing option. A Home Equity Line of Credit (HELOC) enables you to borrow against your home’s equity, offering a flexible line of credit with a set limit.

Unlike a lump sum, funds can be drawn as required, and interest is applied only to the amount utilized. Generally, interest is paid over up to 10 years.

Pros

• Flexible Financing: A HELOC can enable homeowners to borrow in increments, allowing you only to take out what you need for each stage of the ADU construction.
• Save on interest: No need to pay interest on extra money because you borrow based on what you need.
• Interest on Drawn Amounts: You only pay interest on the funds you have used, not on the entire line of credit, which can save you money.

Cons

• Variable Interest Rate: The interest rate on a HELOC is often variable, which can increase the cost of borrowing if rates go up.
• Equity Requirements: Like cash-out refinancing, you will need a substantial amount of home equity, typically between 10% to 20%, for qualification. Most lenders will allow you to borrow up to 80% or 85% of your home’s value minus your first mortgage. For most homeowners without equity, this won’t be an option.

Summary

A Home Equity Line of Credit (HELOC) allows most borrowers to tap into the home’s equity, perfect for projects like ADU construction.

It has lower closing costs, and you only pay interest on the amount you borrow. The amount of current equity limits the homeowner’s borrowing power.

5. Renovation Loans

Overview

Renovation or ADU construction loans are specialized home equity mortgage loans for home projects, including accessory dwelling units.

The key feature is borrowing based on the estimated post-renovation value, not just the current value.

The loan amount is predetermined and paid to your contractor in a lump sum or stages as work progresses.

Pros

• Higher Borrowing Limits: You can borrow up to 90% of your estimated post-renovation property value, offering more substantial funding than traditional home equity loans.
• Future Value Consideration: The loan considers the value the ADU will add to your property, not just its current value.

Cons

• Equity Requirement: While not as much as other loan types, you still need some equity in your home to qualify.
• Low Debt-To-Income (DTI) Needed: Your DTI ratio must be low to qualify, which could be a barrier for some borrowers.
• Interest Rates: Generally higher interest rates than traditional home loans.

Summary

Renovation loans are a great choice to finance an ADU! You’ll need some existing home equity and a low DTI ratio, but they offer higher borrowing limits and flexibility based on future property value.

The catch is you must have existing home equity and a low DTI to qualify.

Other Ways to Assist with ADU FUNDING

There are other ways, such as local ADU programs, ADU grants, and unsecured loans.

CALHFA ADU Grant Program

Overview

Homeowners can apply for a grant of up to $40,000 through the California Housing Finance Agency (CalHFA) to construct an ADU. The grant covers predevelopment costs and is wired to the loan account, reducing the principal amount to be repaid. So this will reduce the total amount you borrow – up to the $40,000 amount.

This product encourages ADU development in higher-cost areas like Los Angeles and San Diego.

Eligibility: The program is limited to homeowners who do not exceed specified income limits and whose properties are within a Qualified Census Tract.

Pros:

• Less Money to Repay: The grant reduces the principal amount, making it a more affordable option.
• Higher Borrowing Power: Grants can be combined with other ADU loan types, offering a higher borrowing limit than traditional refinance loans.

Cons:

• Uncertain Timelines: The program is relatively new, making the process timelines uncertain.
• Paperwork and Oversight: The application process requires a lot of documentation, although services like Otto can assist with this.

Summary:

The CalHFA ADU Loan Program offers significant financial relief to eligible homeowners. Despite its cons, like uncertain timelines and paperwork, it is an excellent option for those who meet the criteria to finance an ADU project.

Local ADU Programs

Local governments often have financial assistance initiatives, including grants, forgivable loans, local ADU funding, and traditional loans designed specifically for ADU construction.

Their goal is to increase affordable housing, and building an ADU behind an existing structure is a great way to fight the housing crisis.

Overview

They usually have certain requirements that homeowners need to meet to apply, such as income limits or property location.

Homeowners may also need to fulfill specific qualifications, like meeting affordability requirements for renting out the ADU.

Pros:

• Localized Assistance: Programs are tailored to local needs and conditions.
• Variety of Options: Grants, loans, and other financial aids are available, providing multiple avenues for assistance.

Cons:

• Limited Scope: Many of these programs are in their pilot stages, accepting only a limited number of applicants yearly.
• Insufficient Funding: The funds provided may not cover the entire cost of constructing the ADU projects for items such as permitting costs.

Summary:

Local ADU programs offer an additional layer of financial aid possibilities.

They can supplement other funding methods well, although they often have restrictions and limitations.

Unsecured Personal Loan or Credit Card

Overview

Unsecured personal loans don’t require collateral like a house or car. You can obtain an unsecured personal loan from various sources, including banks, credit unions, and online lenders.

There is no need to build up equity in your home for this product.

Pros

• No Collateral Required: Since these loans are unsecured, you won’t have to use your home or other assets as collateral, reducing the risk of asset forfeiture.
• Ease of Application: Unsecured loans are generally easier to apply for because they don’t require an appraisal of any collateral.

Cons

• High-Interest Rates: Unsecured loans often come with higher interest rates due to the lack of collateral, making them more expensive in the long run.
• Lower Loan Amounts: Generally, unsecured loans offer lower maximum loan amounts than secured loans, which could be a limitation if the project cost is higher than the money you can borrow.

Summary

Unsecured personal loans provide a quick and collateral-free option to finance an ADU project. They are easier to obtain than secured loans and offer more flexibility.

However, they come with higher interest rates and lower loan amounts.

Final Thoughts

From tapping into home equity investment to exploring the advantages of rent-sharing loans, an array of financing options is designed to turn your property into a rewarding investment.

But the journey doesn’t stop here. Interested in maximizing your ADU’s potential?

Dive into our next article, The 7 Best Prefab ADUs for Your Backyard, to explore design options that are as financially savvy as they are aesthetically pleasing.

Your dream ADU isn’t just a possibility—it’s a decision away. The big question is, which is the best way to finance an ADU for your current situation?