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Financing an ADU: Using your home equity to build an ADU
Home Equity  blog tag

Financing an ADU: Using your home equity to build an ADU

Unlock Your Home's Equity and Build an ADU with These Financing Options

Financing an ADU, doesn't have to be complicated. Especially if you have built up equity in your home. 

Key Takeaways:

  •  An ADU (accessory dwelling unit) is an addition attached to your house, freestanding, or converting unused space (such as a garage) to increase usable living space on your property

  • Financing options for an ADU include those that tap into home equity (including home equity loans, home equity lines of credit, and refinancing) and others (such as construction loans, personal loans, or retirement savings accounts)

  • Using a home equity line of credit (or HELOC) is beneficial because it can offer a low interest rate, repayment flexibility, and increased borrowing power

Accessory Dwelling Units, or ADUs, are a popular way to increase living space, increase property value, and plan for the future. An ADU gives you access to unused space for adult children, aging parents, rental units, or offices. Financing an ADU can be a daunting task, but there are several options available. One of the most popular is to use home equity. Homeowners can borrow against their existing equity and use it to finance the construction of an ADU.

This article explores financing options to turn your ADU dream into a reality.

What is an ADU?

An ADU, or Accessory Dwelling Unit, is an additional dwelling unit on a property that may be used for residential purposes. It can be attached to the main home or detached from it and can be used as a separate residence, an office, or just extra space. ADUs are becoming increasingly popular as homeowners look for ways to increase the value of their properties and accommodate changing needs such as aging parents, adult children, or guests.

In the past, ADUs have gone by other names such as in-law units, backyard cottages, granny flats/pods, and pool houses. However, legally, they go by "accessory dwelling units" and they have skyrocketed in popularity in the past decade. Several factors have contributed to the increased attraction to ADUs. The "tiny house" infatuation, an increase in adult children living with their parents, and an aging baby boomer popular, all paired with increased inflation and living costs, make ADUs a much more attractive option than in the past. 

Depending on your budget, a prefabricated ADU can cost under $100,000, or, if you go the custom-built route, can cost several hundred thousand.

Before you reach out to contractors, it's important to be clear on what you are looking for.

  1. What are the local laws about building an ADU on my property? 

  2. Where will the ADU be located? Will it be attached to your home? Will you be converting a garage or other existing space? 

  3. What is the purpose of my ADU? Will it be used for guests, an office, a rental, or another purpose?

  4. How much will it cost? Can I finance building an ADU? What is my budget?

  5. What will the return on investment be (ROI)?

Financing an ADU

There are many things to consider when financing an ADU. Factors to think about include how much equity you have in your current property, your credit score, and project costs. Once you have determined what it is you are looking for, it is time to explore your budget, which will guide your renovation project.

Using home equity to finance an ADU

One of the most popular ways to finance an ADU is by using home equity. Home equity is the difference between what your home is worth and what you owe on it. If you have built up a significant amount of equity in your home, then you can use it to fund the construction of an ADU.

Options for accessing your home equity:

  1. A home equity line of credit (or HELOC): A HELOC is a rotating line of credit that is secured by your primary residence. HELOC processing can move quickly, so you can get started on your project quickly. With a HELOC, you have an introductory "draw period," where you can withdraw funds as needed, and are only required to make payments on interest. This is typically 10 years. This is followed by a "repayment period" in which you make payments on both the principal and interest. 

  2. A conventional home equity loan: Another equity loan option is a traditional home equity loan. These loans are separate from your existing mortgage, but provide a one-time payment for the entire loan amount. As with HELOCs, they come with lower interest rates than unsecured loans, because they are backed by the equity you have accrued in your home. 

  3. A cash-out refinancing: A cash-out refinance is a mortgage that replaces your existing mortgage. Out of that new mortgage, you receive a lump-sum single payment, which can be used to build an ADU (or for any other purpose).

Other ways to finance building an ADU

If you don't have much equity in your home, there are still options when it comes to financing your ADU.

  1. Traditional bank loans: Personal loans, construction loans, and renovation loans are all available to fund your construction project. 

  2. Cash: If you don't have much equity but have savings, using cash is another way to finance the building of an ADU.

  3. Financing through a prefab ADU manufacturer: Many manufacturers of prefabricated ADUs have financing options that work in a similar way to traditional home loans.

  4. 401k, IRA, or other retirement savings account: Keep in mind, that if you are younger than 59.5, you will likely pay a penalty. Weigh the return on investment you will get from building your ADU, such as rental income and increased property value, to determine if this is the right decision for you.

  5. Borrowing from friends and family

Benefits of using a home equity line of credit for an ADU

If you have sufficient equity built up in your home, using that equity to finance your ADU is the best option due to the lower interest rates than other types of traditional bank loans. It is less risky than tapping into retirement funds and possibly facing financial penalties. It also doesn't have to protentional strain your relationships in the way borrowing from friends. 

  1. Low interest rates: A home equity line of credit, or HELOC, usually comes with a low interest rate of about 4-7%. This is because it is secured by your property, and it makes it a much more affordable option than traditional, unsecured bank loans. 

  2. Tax deductions: Building an ADU can fall under the Tax Cuts and Jobs Act (TCJA, 2017) criteria which allows you to deduct interest paid on a HELOC or home equity loan. According to this tax law, any taxes paid on a home equity loan or line of credit used to "buy, build, or substantially improve" your primary residence can be deducted from your taxes (up to $750,000 in loans for joint filers, or $325,000 for single filers). Of course, you should always contact a tax professional to make sure this applies to your specific situation. 

  3. Deferred payments on the loan principal: With a HELOC, you initially only make payments on interest, and only begin to pay down the principal when you enter the repayment period. This means you can start your project right away and wait until you see the financial benefits (from rental income or increased property value) before you begin to make larger payments.

  4. Withdrawal and payment flexibility: It is impossible to know exactly how much any construction project will cost. A HELOC can be beneficial because you can withdraw funds as they are needed and don't need to pay interest on additional money that you may not need for building your ADU. And even though you don't have to make payments on the principal amount during the withdrawal period, many HELOC options allow you to pay down your principal without penalty. This gives you ideal flexibility when it comes to building. 

  5. Increased borrowing power: When compared with cash-out refinancing and personal loans or construction loans, a HELOC usually gives you access to increased capital in order to build the ADU that meets your needs. 

It's crucial to keep in mind, that all financing options come with risks. Consider all risks and benefits carefully before deciding how to best fund your ADU. Home equity lines usually come with upfront closing costs and appraisal fees which need to be considered in your final decision. It is crucial to make sure that you will be able to continue to make payments on your primary mortgage as well as make monthly payments. If you fail to make payments on a HELOC, you run the risk of foreclosure on your home. 

Conclusion

Building an ADU can add value to your property and improve your quality of living, whether you are building a living space for a young adult in your life, completing a garage conversion, or adding much-needed remote work office space. There are many options available for financing your exciting new endeavor!

 

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