about ADUs (Accessory Dwelling Units) and the different ways to finance them

• ADUs Are Magic
• They provide rental income, multi-generational housing, home office space, retirement downsizing options, etc.
• They also help address housing shortages and affordability.
• But Financing Can Be Tricky
• ADUs contain all the expensive elements of a home (kitchen, bathroom, utility connections) in a smaller package.
• Thorough budgeting and financing plans are essential before starting design or construction.

Three Main Categories of ADU Financing

1. Outside Funds (not from your property’s equity)
2. Equity You Already Have (in your home)
3. Equity You Create (via future value construction loans or renovation loans)

1. Outside Funds

• Cash on Hand
• Easiest if you already have enough savings.
• Many people still use some cash for partial expenses (design fees, permits, site prep).
• Retirement Accounts

1. Loans from 401(k) / Employer Plans

• Typically can borrow 50% of vested balance up to $50k.
• No taxes triggered if repaid properly.
• Job change or layoff could force immediate repayment (otherwise taxes/penalties apply).

1. Retirement Distributions

• Can use IRA or other account withdrawals if you’re over 59½ or taking from an inherited IRA.
• Roth IRAs can be tax-free if it’s a qualified distribution.
• Self-directed IRAs or 60-day rollover “bridge” approaches exist but have complexities—consult a tax advisor.
• Family & Friends
• Gifts or private loans.
• If it’s a loan, have a solid repayment plan (get pre-approved so everyone knows you can refinance and pay them back).
• Credit Cards & Personal Lines of Credit
• Sometimes used to cover last-minute costs (finishing or furnishing).
• Running up high balances can damage credit scores, possibly triggering higher rates and making future refinancing difficult.
• Time your mortgage refinance application before you max out cards to lock in a good credit score.

2. Equity You Already Have

• Refinancing
• Replaces existing mortgage(s) with a larger new loan.
• Generally can borrow up to 80% of your home’s current value.
• Closing costs: around $4k–$5k.
• Lets you choose new terms (fixed vs. adjustable, 15-, 20-, 30-year, etc.).
• Great if rates are decent.
• Reverse Mortgages (for 62+): No monthly mortgage payment (only taxes/insurance), but setup costs are higher and loan balance grows over time.
• Home Equity Line of Credit (HELOC)
• A second mortgage behind your first loan (keeps your existing low rate intact).
• Often allows 80%–90% of current value minus existing mortgage balance.
• Variable interest rates (commonly prime + margin).
• Draw period (e.g., 10 years) where you pay interest only on drawn amounts.
• After draw period, loan switches to a repayment period with higher monthly payments.
• Setup costs usually $0–$1k; sometimes free.
• Home Equity Loan (HELoan)
• Also a second mortgage, but fixed interest rate and fixed term (5–20 years common).
• Higher rate than typical first mortgages, but no surprises on monthly payments.
• Lump sum at closing (unlike the revolving nature of a HELOC).
• Some lenders offer hybrid HELOCs that let you lock portions into a fixed rate.
• Blended Interest Rate
• When you keep a low-rate first mortgage and combine it with a higher-rate HELOC/HELoan, your overall “blended” rate may still be better than refinancing everything at a higher single rate.

3. Equity You Create (Construction & Renovation Loans)

• Let you borrow against the home’s future value (post-ADU).

Construction Loans

• Construction-Permanent / One-Time-Close
• Single closing covers construction and long-term financing.
• Construction phase: 9–18 months, interest-only on funds actually drawn.
• Converts to permanent mortgage after project is done.
• Lender Requirements
• Detailed plans, specs, contractor background check, fixed-price bid.
• Don’t start construction before loan closing (to avoid liens).
• Can close only after you have permits in hand.
• Higher closing costs and generally higher rates than standard mortgages due to increased lender risk.
• Draw process: Lender pays out in stages as work is completed and verified on site.
• Prefab ADUs: Potential conflict because lenders want materials permanently affixed to the property before paying. Deposits to manufacturers might have to be paid out-of-pocket and reimbursed later.

Renovation / Rehab Loans

• FHA 203(k), Fannie Mae HomeStyle, Freddie Mac ChoiceRenovation
• Also based on future improved value.
• Easier and faster to close than full construction loans (often 30–45 days).
• Appraiser sees your plans, estimates value “as improved.”
• Allows for a contingency reserve (10%–20% extra) to handle unforeseen costs.
• Draw process similar to construction loans.
• Rates typically ~1% higher than standard loans; extra closing costs ($3k–$5k).
• FHA 203(k)
• Up to 97.75% LTV on a primary residence (subject to FHA county loan limits).
• May have issues with detached ADUs depending on lender interpretation.
• Fannie / Freddie (HomeStyle / ChoiceRenovation)
• Up to 95%–97% for a primary residence, 90% for second homes, ~75%–85% for investment properties.
• No controversies with detached ADUs (explicitly allowed).
• Payments Start Right Away
• Unlike construction loans, monthly payments on the new mortgage start after closing, although you can finance up to 5 months’ worth if the appraisal supports it.

Appraisals for ADUs

• Hard to find comps because ADUs aren’t sold as often.
• Lenders typically require comparable recent sales with ADUs nearby.
• Keep an eye on local ADU sales; it helps justify higher future appraised value.

Final Thoughts

• ADUs can transform your property’s value, housing options, and income.
• Most people end up mixing multiple funding sources (e.g., partial cash, partial HELOC, partial construction loan).
• Work with a knowledgeable lender who’s done ADU financing to navigate specifics.