Financing Your ADU Dream: A Guide to Construction Loans

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Accessor dwelling units (ADUs), also known as granny flats or backyard cottages, are a hot trend in the world of housing. As housing costs continue to rise across the country, ADUs provide a flexible and affordable housing option for many homeowners Adding an ADU to your property can give aging parents or adult children a place to live, provide rental income, or simply create extra living space

But building an ADU also takes significant financing. Construction costs can easily run upwards of $100,000 or more. As interest in ADUs grows, so have financing options through construction loans tailored to ADU projects. Here’s what you need to know about using a construction loan to finance building your ADU dream

What is a Construction Loan?

A construction loan is a short-term mortgage loan used to finance building a new structure on a property. With a construction loan, the lender distributes funds in stages to pay contractors as they complete phases of the project.

Construction loans take out a single large loan upfront, rather than trying to finance construction in pieces. This lump sum covers all project costs upfront so you can then pay contractors as work is completed.

Construction loans are a type of interim loan, which means they are designed to be replaced by permanent financing once the project is finished. This is usually done by getting end financing through a traditional mortgage.

Why Choose a Construction Loan for an ADU?

Trying to finance an ADU addition in phases with personal loans or home equity financing can be challenging. With a construction loan, you borrow everything you need for the project upfront. Here are some of the key advantages of using a construction loan to finance building an ADU:

  • Cover the full costs in one loan: Construction loans provide funds for all project costs upfront, including materials, permitting, labor, and other fees.

  • Pay as work is completed: The loan is distributed in phases as work is finished, allowing you to pay contractors as the build progresses.

  • Usually lower rates than other options: Construction loan rates are often lower than alternatives like personal loans or home equity loans.

  • Easier qualification than with home equity: You can qualify for the full amount needed based on the future home value, not current equity.

  • Option to refinance into permanent loan: You can refinance into a fixed-rate mortgage once the ADU is complete.

  • Get short-term financing: Construction loans are intended for short-term projects of around 6-12 months.

Construction Loan Rate and Terms

Construction loans have unique features and terms compared to conventional mortgages. Here are some things to know about rates, duration, fees, and repayment on construction loans:

  • Interest rates: Expect a higher rate than conventional mortgages, but usually lower than personal loans or home equity options. Rates range from 5-8% for excellent credit.

  • Loan term: Designed for short-term projects of around 6-12 months. You’ll need to refinance into permanent financing once the project is done.

  • Disbursement schedule: Funds are distributed in stages as phases of construction are completed to pay contractors.

  • Loan origination fee: Usually 2-5% of the loan amount. High fees cover the lender’s increased risk.

  • Repayment: You’ll usually only make interest payments during construction. Once complete, you’ll need to refinance into a standard mortgage.

  • No early repayment penalties: Construction loans can be paid off or refinanced as soon as the project is finished without penalty.

ADU Construction Loan Requirements

Construction loans have stricter eligibility and underwriting requirements than standard mortgages. Here are some key things lenders will evaluate:

  • Credit score: You’ll need a good or excellent credit score, usually 680 and above.

  • Debt-to-income ratio: Lenders want to see a DTI of 36-45% or lower.

  • Loan-to-value ratio: The loan amount is based on the expected home value after construction, usually 80-90% LTV.

  • Contractor qualifications: For an ADU build, lenders want to see experienced, licensed contractors.

  • Plans and permits: Detailed project plans and permits are required before loan approval.

  • Cash reserves: Expect to need 20-25% of the project cost in cash reserves.

Meeting these requirements demonstrates to the lender you can repay the loan. Providing detailed project plans and experienced contractors also minimizes risks.

How Much Can You Borrow?

The amount you can borrow with a construction loan is based on the expected home value after the ADU is built. This is different than home equity financing, which bases the loan amount on your current home value.

Lenders will evaluate the current value of your home along with the expected added value of the ADU to determine the future total property value. Loan amounts of 80-90% of this projected future value are common.

For example, say your home is worth $500,000 currently. The lender estimates adding a 750 square foot ADU will make the future total property value $700,000. At 80% loan-to-value, your maximum construction loan amount would be $560,000 (80% of $700,000). This allows you to finance the full ADU construction even if you have limited current home equity.

The Construction Loan Process

Getting a construction loan involves much more detail and oversight than a conventional mortgage. Here are the general steps to receive ADU construction financing:

1. Submit full project details – You’ll need to provide detailed plans, permits, a complete budget, and contractor qualifications. The lender needs to review project feasibility.

2. Get pre-approved – The lender will evaluate your income, assets, credit, and project plans to pre-approve you up to a certain loan amount.

3. Find a contractor – With pre-approval, you can get bids from contractors and finalize building plans.

4. Provide final plans and budget – Submit final plans, costs, and contractor agreement for lender underwriting.

5. Loan closes – The lender will finalize loan approval and set up the disbursement schedule.

6. Construction begins – Once the loan closes, construction can start. The lender distributes payments on a draw schedule as work phases complete.

7. Project completion – When construction is done, the home must pass inspections before final payment.

8. Refinance for permanent financing – You’ll need to refinance into a conventional mortgage once the ADU is complete.

It’s a detailed process with lots of oversight. But going through full underwriting upfront ensures you get the funds needed to successfully finance and complete your ADU project.

Finding the Best Construction Loan Lender

The lender you choose can significantly impact your construction loan experience. Here are some tips for finding the best lender:

  • Check construction loan experience – Find lenders with extensive ADU and construction financing experience.

  • Ask about draw schedules – The best lenders provide detailed payment draw schedules.

  • Look for local knowledge – A lender familiar with contractors and regulations in your area is helpful.

  • Review rate and fee transparency – Beware of hidden fees. Look for clear rate and cost disclosure.

  • Compare customer service – You’ll be working closely with your lender, so good communication is key.

  • Check for refinancing support– Make sure the lender can guide you through refinancing into permanent financing once construction is complete.

ADUs involve much more complexity than conventional mortgages. Finding an experienced construction lender you can trust makes the financing process smoother.

Alternatives to Consider

While construction loans are the most comprehensive option, they aren’t the only financing choice. Here are two alternatives to look at:

Home Equity Loan

  • Pros – Can keep current low mortgage rate. Approval based on home’s current value.

  • Cons – Limited to 15-20% of current value in most cases. Higher interest rate than construction loan.

Cash-Out Mortgage Refinance

  • Pros – Can access your existing home equity. Usually lower rate than home equity loan.

  • Cons – Gives up current low mortgage rate. Limited to 80-85% of current home value.

These options may work if you have significant equity and your ADU project is small. But for major renovations, a construction loan is usually the best fit.

Tips for Managing Your ADU Construction Loan

If you decide to finance your ADU with a construction loan, here are some tips to make the process go smoothly:

  • Review all draw schedules, budgets, and timelines thoroughly before signing. Hidden costs can spiral.

  • Get everything in writing upfront – details, fees, rate locks, draw schedule. Verify there are no last-minute surprises.

  • Have a detailed contractor agreement in place ahead of time to prevent disputes down the road.

  • Get all inspections and permits done early. Delayed approvals can

A short summary of loan products for financing an ADU

construction loan for adu

A cash-out refinance is a type of mortgage that refinances your primary mortgage and uses your existing home equity to access cash to pay for construction. Essentially, you get additional cash while taking on a larger mortgage.  Cash-out refis typically allow you to borrow up to 80% of your home’s current value.  You pay the loan back over 15 to 30 years, just like a standard mortgage. Â

Cash-out refis come with significant advantages, especially for borrowers with good credit and high home equity:

  • Cash-out refis are widely available, tend to be quick to close, and have few fees.
  • Relative to other major lending products, you’ll pay a moderate interest rate (about 0.5 points higher than a standard mortgage).  The interest rate is fixed, so you’ll lock in a low rate as interest rates likely rise in the future.
  • The use of funds is flexible — you pay the contractor as key milestones are completed.

However, this approach won’t work for everyone:

  • If you don’t have much home equity (for example, if you only recently bought your home), a cash-out refi won’t provide enough cash to pay for an ADU project.
  • Also, a cash-out refi is a new primary mortgage, requiring you to retire your current mortgage.  If you’ve recently refinanced your existing mortgage and locked in a low interest rate, you may not want to retire your current mortgage.

A home equity loan is a type of second mortgage that you carry alongside your existing mortgage. Like a cash-out refi, it uses your existing home equity to access cash to pay for construction.  You can typically borrow up to 80% of your home’s current value. Â

Once the loan closes, your lender will pay you the total loan amount, so it’s a good idea to determine your budget before applying for the loan.  You pay the loan back in consistent monthly payments (both interest and principal) over 10-30 years.

Home equity loans are a great option for borrowers with good credit and high home equity:

  • They’re widely available, and quick to close.
  • Relative to other major lending products, the interest rate is moderate, and the interest rate is fixed.
  • The use of funds is flexible – you pay the contractor as key milestones are completed.
  • Crucially, you don’t have to retire your existing mortgage in order to get a home equity loan — a major plus if you’ve previously locked in a low rate on your mortgage.

However, if you’re a relatively new homeowner without much home equity, a home equity loan probably won’t provide enough cash to pay for an ADU.

A home equity line of credit (HELOC) is very similar to a home equity loan; it’s a second mortgage that taps your existing home equity for cash.

A few key differences:

  • A line of credit gives you the right to borrow up to a predetermined amount, but you don’t have to borrow it all at once.  Instead, you withdraw funds as project milestones are achieved, and you only pay interest on the amount you withdraw.
  • During a “draw period” of 5-10 years, you only pay interest.  Then, during a repayment period of 10-25 years, you pay the loan back in consistent monthly payments (both interest and principal).
  • HELOCs typically have a variable interest rate, which means that your monthly payments will increase if interest rates rise in the future.

As with home equity loans, HELOCs are a great option for borrowers with good credit and high home equity.  They’re a less effective option for relatively new homeowners without much home equity.

A renovation loan is a type of mortgage that provides funding for home renovation, as well as for the purchase or refinance of the home itself.  If you already own your home, it replaces your existing mortgage and provides you with the cash needed for the ADU project.  You’re charged a relatively low fixed interest rate, and you pay the loan back over 30 years, just like a standard mortgage.

Two commonly-used renovation loans are the Fannie Mae HomeStyle and the FHA 203(k) loan. Â

Unlike other loan types, renovation loans allow you to borrow about 95% of your home’s value post-renovation (essentially, what the home will be worth with an ADU).  If you don’t have much home equity, this can help you access enough funds to finance ADU construction.  This can also be a good option for homeowners who don’t have high credit scores.

However, renovation loans can be challenging:

  • Relatively few lenders offer these loan products – you’ll have to shop around and contact multiple lenders.
  • You’ll have to refinance your existing mortgage to pay back the construction loan.  If you have a low interest rate on your mortgage, you may not want to retire your current mortgage.
  • They’re often slow to close – expect the process to take up to 90 days.  Delays are common, especially when a lender lacks experience with renovation loans.
  • Before the loan is approved, a third-party consultant will have to approve your contractor’s budget, and the lender will want to see that the city has approved your building permit.  This can slow down the loan closing process.
  • The lender is unlikely to let you change the project budget after it’s locked in.  You may have to pay out of pocket for cost overruns.
  • During construction, the third-party consultant has to certify that key milestones are met before the lender will approve payments to the contractor (the “draw schedule”).  This can slow down contractor payments (and the next stage of construction), which is why some contractors avoid projects that are financed with a renovation loan.

A construction loan is a short-term loan (typically 1-2 years) that can provide financing for building an ADU.  Like a renovation loan, a construction loan is based on an estimate of what the home’s value will be after the ADU is completed.  This allows you to borrow up to 80-95% of the home’s value post-construction.

There are two main types of construction loans:

  • Construction-to-permanent loan: this loan provides funds for ADU construction, and when the project is complete, the loan converts to a standard mortgage with a 15-30 year term.  Since it’s a single loan product, you only pay closing costs once.
  • Construction-only loan: this loan also provides funds for ADU construction.  At the end of the term (1-2 years), the borrower must either pay the loan back in full or get a mortgage or home equity loan to provide permanent financing.  While this allows you to shop around for permanent financing (and avoid retiring your primary mortgage if you refinance into a home equity loan), you’ll pay closing costs twice.

A construction loan can be a good option for homeowners without high home equity. Â Additionally:

  • Construction-to-permanent loans issued by credit unions often have low interest rates and can offer fixed rates, allowing you to lock in low rates over the long term.
  • As with HELOCs, you withdraw funds as project milestones are achieved, and you only pay interest on the amount you withdraw.  You don’t have to pay back principal until after the project is completed.

However, construction loans aren’t for everyone:

  • Interest rates vary widely, and construction-only loans tend to have high interest rates.
  • Relatively few lenders offer construction loans – you’ll have to shop around and contact multiple lenders.
  • Before a lender will issue a construction loan, you’ll need a home appraisal confirming that an ADU will add significant value to your property.  ADU appraisals are sometimes inconsistent and have historically undervalued ADUs (particularly those that convert existing living space).
  • Your ADU project must be completed by the end of the term of the loan.
  • A construction-to-permanent loan will retire your current mortgage once the project is complete. Â If you have a low interest rate on your mortgage, you may not want to retire your current mortgage.

Private money is similar to a construction-only loan: it refers to a short-term loan (typically 1-2 years) that’s used to finance ADU construction, and is paid back at the end of the project, typically by refinancing into a standard mortgage.  However, while construction loans are issued by banks and credit unions, private money comes from private investors — this could be family, friends, accredited investors, or private money lenders (“hard money” lenders).

Private money can make sense for some groups of property owners, particularly owners of investment properties who want to add ADUs to a rental property. However, these can be very risky loans for most homeowners: interest rates are generally high (between 6-12%), and you will have to put up property (most likely your primary residence) as collateral. Â Standard lending products, like cash-out refis, home equity loans, renovation loans, and construction loans, typically offer much more advantageous terms.

Budgeting for an ADU

A good first step is to plan out a simple project budget.  You can expect to pay about $250-350/sqft for an ADU that’s built in converted space, and about $350-450/sqft for an ADU that’s built in new space.  So a typical 1-bedroom, 600 sqft ADU will cost between $150,000 and $270,000.  This ballpark estimate includes soft costs (a survey, designs, permit fees, etc.) and hard costs (lumber, appliances, labor, etc.)

For a more precise estimate of project cost, check out our ADU Budget Calculator.

It’s also wise to have cash savings to put towards the ADU project, even if you plan to pay for most of the project with a loan.

  • Having cash on hand will help your project move faster — for example, you can pay for a contractor site visit, designs, and permits while you’re waiting for a loan to close.
  • Many loan products will require a down payment, and may include upfront fees or other closing costs. Â Having cash reserves may also help you access lower interest rates.
  • You can use cash savings to pay for a contingency in your budget — essentially, a small reserve fund that you can use if there are cost overruns.

Of course, few of us have enough cash savings to pay for an entire ADU project, which is why most homeowners get a loan to finance their ADU.  While you have many different financing options available, each lending product comes with its own pros and cons.  The right choice depends on your individual financial situation, your home’s value, and the amount of debt you already have outstanding on your home.

Commonly used lending products include:

  • Cash-out refinance
  • Home equity loan
  • Home equity line of credit (HELOC)
  • Renovation loan
  • Construction loan
  • Private money

How To Finance An ADU When You Don’t Have Home Equity

FAQ

How to get a loan for an ADU in California?

Funding an ADU in California can be accomplished with many different types of financing options including a Home Equity Line of Credit (HELOC), Home Equity Loan, Cash-Out Refinance, or 203k Loan, and with California Housing Finance Agency’s (CalHFA) Grant Program.

Can you use a 203k loan for an ADU?

Yes, the FHA 203k loan allows you to use it for an ADU, but you need to be aware of certain parameters. For starters, the ADU must be either attached to the main house by a common wall or be a conversion of an interior space of the main home. This can include conversions of garages attached to the main house.

What is the term of the ADU loan?

However, this loan may come with a higher interest rate than other loans and with a variable interest rate that may go up over time, so make sure to compare your options. Also, depending on your lender, the term of this loan can range from 10-30 years, either interest-only or fully amortized.

How much does an ADU cost in California?

Overall, the cost of an ADU can range from $300,000 to more than $400,000, depending on how they’re constructed and furnished.

Are construction loans a good option for building an ADU?

Construction loans are a one-size-fits-all solution and are not based on your specific needs and requirements, meaning that there are likely better options to help you pay for building an ADU. Personal loans and credit cards are categorically not the most suitable approach to financing an ADU.

Can I get a loan for an ADU?

Yes, you can get a loan for an interior, attached, or detached ADU. Most homeowners use either a secured loan or unsecured loan.

What financing options are available to build an Accessory Dwelling Unit (ADU)?

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. Learn how much it costs to build an Accessory Dwelling Unit (ADU) and how to finance it.

How do you finance an ADU?

There are two main ways to finance construction of an ADU on property you already own: Either keep the current mortgage and borrow equity through a home equity loan or home equity line of credit; or refinance the mortgage, replacing it with a construction loan or renovation loan. Will you rent it out?

Do new homeowners need Adu financing?

New homeowners who have not yet built up enough equity in their homes may need to use unsecured loans, while those with credit challenges may be more likely to qualify for a secured loan, if they have sufficient home equity. A little later on we will dive into more detail on ADU financing options.

What financing options are available for an ADU?

Use our ADU financing calculator to look at several different loan options, including Renovation Loans, HELOCs, and Cash-Out Refinance. You can include the estimated costs for your ADU that are based on our actual plans and prices.

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