ADU Loan Options: What type of loans are available to me?

Building a secondary dwelling on your property makes sound financial sense because you may use it to earn additional income. An accessory dwelling unit (ADU) is an ideal opportunity to provide extra living space separate from your residence. A small self-contained ADU detached from the main house on your block can be useful in a variety of ways. It can function as:

  • A home for older relative/s, like grandparents
  • A home for your teenager or grown-up child
  • Accommodation for guests
  • An air BNB holiday rental
  • A permanent rental proposition
  • A hobby or art studio
  • A home office

Not only can an ADU earn rental income (holiday or long term), but it will increase the value of your property. When you list your property for sale, the sale price will typically be higher for having a second living space. Many buyers are searching for homes that also cater to other family members. Giving them the ability to live close by while keeping their own independence. Furthermore, the income-producing potential of a secondary dwelling appeals to buyers who recognize the value of having two dwellings on their new property.

What is a Casita or ADU?

In California, a casita refers to a small house or habitable building. The term derives from Spanish, meaning a little, self-contained dwelling. As well as being a guest house or a Granny flat, it can provide holiday rental accommodation. By definition, the casita is separate from the main house but occupies the same property. It is just another term for an ADU.

When adding a casita to your property, there is more than one way to achieve your goal. Typically, the homeowner will have plans drawn up and have the casita built on site. However, a quicker solution is to purchase an existing small building, and have a trucker deliver it to your property where you can immediately establish it n foundations, like steel piers and beams. You would, of course, be restricted to purchasing a removal building that is not on concrete foundations. Alternatively, the ADU can be built in a factory, much more quickly than an onsite build. And the prefabricated casita can be trucked to the site and immediately installed on piers or onto crawl space foundations.

What Type of Finance is Available for an ADU?

Having decided on building an ADU on your property, there is the question of how you are going to finance it without sufficient savings on hand. Most homeowners will need to apply for a mortgage to fund or partially fund the ADU. A popular way to finance a proposed ADU is via a renovation loan. When assessing the lending application, the financier will calculate the value of the property when completed with both dwellings. This method considerably increases your borrowing power. The financier may also factor in earning potential if you propose to rent the second dwelling and provide rental projections supported by your realtor or the lender’s valuer.

A home addition loan that you may draw on as the building progresses is a home equity line of credit (HELOC). This is like a second mortgage. And it enables the homeowner to borrow against the equity they have already built up in any property they own. This equity may be in their principal place of residence or perhaps in some investment property they have. Equity is the difference between the market value of your home and any balance still owing on the property’s mortgage. The financier uses the homeowner’s property as collateral for the line of credit. But there can be several upfront fees like loan application and valuation fees and legal costs to establish the HELOC.

An Ideal ADU Loan Leverages Your Equity

A home equity loan (HEL) also accesses the equity already built up in the existing property and can be borrowed as a lump sum and applied to the construction of the ADU. This type of loan offers fixed interest terms whereas the HELOC has variable interest rates. There are, however, other avenues for financing the addition of an ADU. The homeowner can apply for a cash-out refinance, whereby they refinance their current mortgage for a higher amount based on equity and use the extra funds for building the ADU. This results in just one loan over the entire property including both dwellings, rather than having two loans. As with a first mortgage, the newly increased loan should have a more attractive interest rate than a HELOC.

There is another viable avenue for funding the building of a second dwelling that will provide expanded family accommodation or earn passive income.  A construction loan can prove to be an ideal ADU loan option. This is a short-term loan. Meant only to cover the cost of building the casita during the construction process. When the second dwelling is complete, the homeowner will then apply for a new mortgage to cover the entire property with the one primary loan. Going this route will attract further loan fees in the long run and the short-term construction loan will be at a higher interest rate than the primary loan.

An alternative method of financing is a construction-to-permanent loan whereby the homeowner takes out a construction loan that converts to a first mortgage when the building is completed. One advantage of this style of financing is that during construction, the borrower can make interest-only payments.

A homeowner planning to add extra living space to their property needs to ensure they have some cash funds in reserve. This is necessary to cover initial costs like a designer or architect to prepare the working drawings, feasibility studies, and town planning reports where required. Then there are upfront engineering costs and permit fees that may not be covered by your financing. However, the end result can be very satisfying, with a new dwelling on the property that opens up a lot more flexibility in living arrangements and provides the potential for passive income.