Building an accessory dwelling unit—or ADU—can be a great way to increase your living space or generate rental income, but it’s important to understand the costs involved, including financing. With the right combination of equity, loans, and grants, you can add value to your property with a quality ADU and enjoy the benefits of added living space.
What Is an Accessory Dwelling Unit?
An ADU is a secondary dwelling unit on an existing residential property. It can take the form of a basement apartment, garage conversion, backyard cottage, laneway house, or other small units that can be used as rental housing or for accommodating family members or other guests.
ADUs are becoming increasingly popular because they provide additional living space without taking up valuable real estate. They may also allow homeowners to generate extra income by renting out the unit.
Cost to Build an ADU
The cost of building an ADU depends on a number of factors, such as size, location, and type of construction. Generally speaking, though, the typical price to build an ADU starts at $200 per square foot and goes up from there. This may result in total construction costs from $50,000 to well over $100,000.
ADU Financing Options
Money can be a significant hurdle when building an ADU, so it’s essential to explore all the financing options available. Here are some common ways to cover the costs of building an ADU:
Home equity line of credit (HELOC)
If you have equity in your home, you can use that as collateral to borrow money against it and finance the construction of your ADU. A home equity line of credit—or HELOC—lets homeowners access up to 85% of their total equity in their home and borrow against it on an as-needed basis. Interest only accrues on the outstanding balance, not the entire borrowing limit, with interest-only payments due monthly over the draw period of the loan. This can be a good option for homeowners who plan to pay for ADU projects over time.
Home equity loan
As with HELOCs, home equity loans are secured by the borrower’s equity in their home. In contrast to a HELOC, home equity loans are disbursed as a lump sum and then repaid on a set schedule. However, interest accrues on the entire loan balance for as long as a balance remains due. For that reason, home equity loans are best for homeowners who want access to all of their cash upfront.
With a cash-out refinance, homeowners can take out a new mortgage to replace their existing mortgage and get access to the equity in their home. This option may be more attractive than other financing methods because it typically offers lower interest rates and longer repayment terms than home equity loans. It also gives homeowners increased flexibility in how they use their loan proceeds.
A construction loan is designed specifically for financing a large project like an ADU and allows you to pay only for what has been completed rather than paying for the entire project upfront. This can be a great option if you need short-term financing but intend to refinance the loan when construction is complete. However, it may not be an option if you don’t have much equity in your property already.
Unsecured personal loan
Personal loans are unsecured loans that don’t require collateral or equity in the borrower’s home. Interest rates tend to be higher than with other types of financing. Still, loan terms are often longer, so they may still be an attractive option for borrowers who don’t have much home equity or are unwilling to put it at risk.
Using a credit card to finance an ADU project may be an option for some, but it comes with some serious risks. Interest rates are typically higher than other financing methods, and there is no tax benefit associated with using a credit card. Additionally, the limits on most credit cards won’t be enough to cover the entire cost of building an ADU. However, using a credit card to finance certain parts of the ADU construction process (such as buying materials) can let homeowners earn cash back or other rewards in the process.
Government grants and incentives
Depending on where you live, there may be grants or other incentives available to help finance your ADU project. These are most common in blighted areas or those where local governments are trying to draw investment dollars into their local communities. Research what’s available in your area and take advantage of any that could help lower your upfront costs.
How to Finance an ADU
The process for financing an ADU varies depending on the lender and the type of loan. In general, though, prospective borrowers should follow a few steps:
- Check your credit score. Your credit score will have a major impact on the type and cost of a loan you can get. Make sure you know your score before starting the process, as this will be important when determining the right lender and financing option for you.
- Evaluate your construction costs. Make sure you have a detailed budget for the construction of your ADU so you know exactly how much financing you need. The cost of building an ADU is largely dependent on its size and the type of construction materials used. Get a good idea of the total costs involved and when you will incur each expense.
- Determine the project timeline. Before applying for a loan, you should have a plan for when the construction will be completed and when payments will be due. Most lenders want to know your expected timeline so they can determine how long they’ll need to provide financing.
- Research lenders and get pre-approved. Different lenders offer different loans at different rates and terms, so make sure you take the time to shop around and compare. Where possible, get approved for financing so you know how much you can spend on the ADU.
- Gather documentation. Most lenders require documentation of your income, assets, and credit score, so take note of what documents will be needed and start putting them together.
- Submit an application. Once you choose a lender, submit the application materials. These usually include identity verification documents (a passport or driver’s license and birth certificate), proof of income, bank statements, and other financial documents, as well as your intended use of funds and a schedule of costs to be covered with your loan.
- Await approval and funding. The lender will review your application and give you a decision within a few days or weeks. Once approved, you’ll receive the funds needed to begin construction on your ADU.
Building an ADU can be a great way to add value to your property and provide additional living space for family members or rental income. Before you can start building, however, make sure you have adequate financing in place. By researching your options and comparing rates, you can ensure that your ADU project is completed on time and within budget.
Frequently Asked Questions
Is an ADU worth the investment?
Whether an ADU is worth the investment depends on the homeowner’s financial circumstances and other factors, like location, the total price point for the property (with and without an ADU), and the real estate market’s health overall. That said, building an ADU can be a great way to increase the value of your property and generate additional income. Whether it’s for family members or as a rental unit, an ADU can provide many benefits.
How much equity does an ADU add?
An ADU can add significant equity to your property. The exact amount will depend on a variety of factors, including the size and quality of the unit, as well as its location. However, in general, an ADU can add anywhere from 15% to 25% of the home’s value to its resale value.
Are there any incentives available to help finance my ADU project?
Many states, cities, and counties offer incentives such as tax credits or loan programs to help homeowners finance their ADU projects. These programs vary drastically by location, so research what’s available in your area and take advantage of any that could help lower your costs.
What is the best way to finance an ADU?
The best way to finance an ADU depends on your individual financial circumstances and the availability of incentives. Generally speaking, some of the most common financing options include home equity loans or lines of credit, personal loans, and government-backed loan programs. Speak with a mortgage lender or financial advisor to determine which option is right for you.