7 Ways to finance a home addition

If you’re a homeowner who is looking for a way to earn some rental income or would like to add value and function to your property, an accessory dwelling unit or ADU might be a good idea. An ADU is an add-on living space built on the same property as a single-family house. 

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ADUs typically consist of at least one bedroom, a kitchen, and a bathroom and can be used as a guest house, in-law suite, office space, or just about anything else. As long as it’s built properly, an ADU usually offers an excellent return on investment of 5% to 10%, depending on property details and local market conditions.

Cost estimation and budgeting

On average, an ADU costs between $150 and $300 per square foot. As you estimate the cost of building an ADU and create a comprehensive budget, be sure to consider the following factors:

• Size: The average size of an ADU is between 600 and 1,200 square feet. Of course, the larger your ADU,  the more you’ll pay for it. 
• Type: An ADU can be an attached unit or detached unit. In general, separate, standalone units will run you more than units that are attached to your property. 
• Design and Materials: Be prepared to pay for the design of your ADU in addition to the build. Oftentimes, design costs are 10% to 15% of the total project cost. You’ll also need to account for material costs, which may be anywhere between 45% to 50% of the total. 
• Foundation: The foundation is an important component of an ADU and typically costs between $4 and $25 per square foot. If you opt for an above-garage ADU, you might spend more on the foundation as you’ll likely need greater structural support to ensure stability. 
• Systems: To meet coding regulations, your ADU will require electrical, plumbing, and HVAC. On average, these systems range from $3,400 to $10,400. If your local or state regulations call for additional requirements, like solar panels, for example, your costs will increase. 
• Labor: Unless you have plans to build your ADU on your own, expect labor costs of about 40% of the total project cost. You’ll need to hire several types of professionals, including an architect, plumber, electrician, structural engineer, and general contractor. 
• Permits: You won’t be able to build an ADU without a permit. While permit costs depend on where you live, the average cost of a permit is $1,350. Do your research and determine permit pricing and regulations long before you start the design process.
• Unforeseen expenses: Unfortunately, things don’t always go as planned and you may face unexpected expenses along the way. A good rule of thumb is to set aside 10% to 20% of your total project cost for a contingency fund to cover any surprises that might pop up during your ADU’s construction. 

Financing an ADU

There are a number of ways to finance an ADU. Before you decide how you’ll pay for your project, it’s a good idea to consider all your options and weigh the pros and cons of each one. Here are several financing solutions to explore: 

Grants

Depending on where you live, you may qualify for a grant to help build your ADU. California, for example, has a grant program for low and moderate-income residents who are interested in ADUs. It can cover up to $40,000 in construction costs. While you won’t have to repay the money you receive, a grant can be difficult to secure and it may not be an option if your income exceeds a certain range. In addition, grants for ADUs aren’t available everywhere. 

FHA 203(k) loans

Issued by the Federal Housing Administration (FHA), FHA 203(k) loans are designed to help homeowners fund qualifying improvements, including ADUs. Compared to other types of loans, they’re easier to get. To qualify, you’ll need a minimum credit score of 500 as well as a down payment of 3.5% or 10%, depending on your credit. You might also have to meet specific borrowing limits, which are based on where you live. In addition, you’ll be required to work with a HUD consultant who will oversee the entire building process. 

Personal savings and cash reserves

If you have a significant amount of cash saved up, you may want to put it toward an ADU. This is particularly true if you’d like to avoid debt as well as the process of applying for a loan and paying it back. While using your personal savings and cash reserves can be a great choice, it may also drain your savings. That’s why you should only consider it if you know you’ll be able to leave a healthy emergency fund. You can also use cash to fund part of your ADU and opt for a loan to pay for the remaining costs. 

Refinancing

A cash-out refinance replaces your current mortgage with a larger one so you can pocket the difference and use the cash to cover anything, including an ADU project. The amount you may borrow will be based on the equity you have in your home and is typically up to 80% of your home value. If you do choose a cash-out refinance, note that you might be on the hook for private mortgage insurance (PMI) and will have to pay closing costs. 

Home equity loans

Also known as second mortgages, home equity loans allow you to borrow against your home equity and offer a lump sum of money upfront. You can secure a fixed interest rate and calculate your payments in advance. However, you’ll need a credit score of at least 680, a debt-to-income ratio of no more than 43% and at least 16% of the equity in your home. Plus, you may be charged closing fees of 2% to 5% of your credit amount. 

Home equity lines of credit

Home equity lines of credit or HELOCs are revolving credit lines that are similar to credit cards. Upon approval for a HELOC, you can pull funds as you wish, up to your set credit limit. You’ll only pay interest on the amount you borrow instead of the entire amount you’re approved for. While every HELOC lender has their own unique requirements, most look for a minimum credit score of 670 and 15% to 20% home equity in your home. Keep in mind that if you withdraw more money than you can repay, you might end up in a serious cycle of debt. 

Home Equity Investment

Just like home equity loans, Home Equity Investments (HEIs) provide a lump sum of cash you can use to pay for an ADU and build wealth.  If you take one out, you won’t have to make any monthly payments. Instead, you’ll pay back the amount you receive as well as a percentage of your home’s future appreciation through a home sale, refinance, or another funding source at any time during a 30-year term.  Although you will need to meet minimum credit requirements for an HEI, you’ll find that they’re usually more lenient than other loan options. 

Final thoughts

No matter your age or stage in life, an ADU can be a smart addition to your property. Before you commit to building one, however, carefully review the various financing options at your disposal. This way you can make the most informed decision and keep your finances intact. If you’re interested in an HEI for your ADU project, don’t hesitate to prequalify and see how much you can get.