For homeowners that are considering building an Accessory Dwelling Unit (or ADU), one of the biggest hurdles is often financing the construction. It is common practice to begin by figuring out a budget and then design and build to that budget. The first step should be finding out how much you can qualify for and how much you can realistically afford. In most cases, an ADU will generate positive cash flow even if it is constructed with entirely borrowed funds.
There are Five ways to finance an ADU. Each has its advantages and disadvantages. The key is to work with a professional with knowledge in each area and develop a funding strategy that best suits the unique situation of the customer.
#1 HELOC (Home Equity Line of Credit)
A HELOC is a second mortgage for homeowners to utilize to access some of the equity in their home. These are adjustable rate loans with interest rates around the Prime Rate. They typically have a 30-year amortization with a 10-year Interest Only period. So, HELOC customers have the option to pay interest only (like you can do on a credit card) without needing to repay any principal. After 10 years, the loan goes to fully amortizing, meaning the customer must make a payment high enough to repay all principal and interest in the remaining 20 years of the loan term. HELOCs are good for smaller loan amounts that can be paid back in a short term. HELOCs can have a loan to value from 80% to 100% of the appraised value of the home.
#2 Cash Out Refinance
A cash out refi is a mortgage that pays off an existing mortgage and gets additional cash out. These loans typically have a fixed rate and a 30-year amortization. There are closing costs associated with a refinance, but they are rolled into the new loan amount and are not required to be paid out of pocket. The payment will be higher than a HELOC because the borrower is making a fully amortized payment from the beginning. The benefit of a refinance is that the principal and interest payment will remain constant over the life of the loan. Most cash out refinances can go to 80% of the appraised value of the home.
#3 Construction Loan
A construction loan is a specialized loan product where the appraisal is based on the after completed value of the home. The closing costs and interest rates on construction loans are typically higher than on a standard refinance. If a borrower wants to remodel their home and does not have sufficient equity based on the current home value, a construction loan, looking at the after improved value instead of the current home value, may be necessary.
Example:
Standard refinance
- Current home value: $400k
- Current loan amount: $200k
- Standard cash out refinance to 80%: $320k.
- Cash out: $120k minus closing costs.
Construction loan
- Current home value: $400k
- After renovation home value: $500k
- Current loan amount: $200k
- A construction loan to 80% of after improved value: $400k.
- Funds available for construction: $200k minus closing costs.
#4 Personal Line of Credit
Many banks offer personal lines of credit for borrowers with good credit scores and income. These lines are typically free to set up and can range from $10k to $50k. They are, however, at higher interest rates than mortgages and HELOCs. They typically require less documentation than a full mortgage.
#5 Cash/Other
Some people have cash on hand for home renovation/remodeling projects or pull cash from retirement or investment accounts. There are no costs for using these funds unless they are pulled from an IRA or 401k where there are early withdrawal penalties. The only “cost” associated with using these funds is the opportunity cost of not being able to utilize these funds elsewhere.
This was a guest article provided by Eric Dunlap, a mortgage advisor at Peak Mortgage.
Eric Dunlap
503-546-0460
edunlap@peakmtg.com
We Lend Where We Live
If you, or anyone you know, are thinking about financing and building an ADU, give him a call! He will be happy to help and would love to be a resource for you.
