How to Finance an ADU in California
What are the rules and regulations of building a tiny home where I live?
Most people underestimate the cost of building an ADU in California and are disappointed when they discover they can’t convert their garage for $20,000.
Accessory Dwelling Units come with all the same expenses as building a brand new home, but without the ‘cheap’ square footage like a bedroom or hallway to offset the expensive square footage, like the kitchen and bathrooms.
Plus, there are a lot of fixed costs to building a home regardless of how big that house is.
Here are 7 ways to finance an ADU in California:
Your Bank Account
If you can afford to pay for things out of investments or a bank account, congratulations. This is the easiest and quickest way to finance your tiny home. However, because of the substantial six-figure expense of a granny flat, this isn’t an option for a lot of homeowners. Most homeowners who build a granny flat have to borrow money to finance their project. Even if you do finance, you’ll have to pay something out of pocket so expect to tap into savings for your project regardless.
Ok, so what are the loan options for an ADU in California?
How to Finance an Accessory Dwelling Unit with a Home Equity Line of Credit (HELOC)
A home equity line of credit allows a homeowner to borrow money from a lender where the collateral is the borrower’s equity in his or her house before any improvements are added. Typically, homeowners must have at least 10% equity in their home or 20% if an investment property or second home.
A Home Equity Line generally has $500 or less in Lender Fee’s. Depending on the equity in your home a Lender may only require a drive by appraisal (never start any construction work until AFTER you have your loan)
Essentially, a lender agrees to lend to a maximum amount and a timeframe; then you can use your home equity line of credit like a credit card and only pay interest on your average daily balance owed. A typical Home Equity Line (HELOC) is for 25 or 30 years and the first 10 years is a draw period with interest only payments. After 10 years your monthly payment requires principal and interest payments to pay off your loan in full at maturity.
If you default on your loans, your home will be foreclosed on. HELOC’s are usually used for significant life expenses like medical bills, education or, you guessed it, home improvements. It’s not uncommon for a bank to want an appraisal done on the house before granting a loan.
Let’s say your home is appraised by the lender at $550,000 and your mortgage balance on your 1st mortgage is $300,000. At 90% of the appraised value you have $495,000 mortgage lien capacity. This would give you a $195,000 Home Equity Line for whatever use you want to use the money for. ($550,000 value x 90% = $495,000 – $300,000 1st mortgage)
If you have equity in your home, this is the next most straightforward way to finance a granny flat. This method is a common way to finance a granny flat. It allows a homeowner to leverage the value in their home, making improvements, which will lead to an increased value in the property.
How is a HELOC different from a Home Equity Loan?
A Home Equity Loan provides a homeowner with a fixed amount of cash and a set repayment schedule. Like a HELOC, the collateral is your home. A HELOC is structured as a revolving line of credit. A revolving line of credit gives funds to someone when needed. Here, the amount needed can fluctuate from month to month. This will have shorter repayment terms and only charge you interest on the amount a homeowner has withdrawn.
So, if your HELOC allows you access to 170K, but you’ve only pulled out 20K, you’ll just be charged interest on the 20K.
How to Finance an ADU with a Construction Loan in California
A construction loan evaluates what the future value of the property will be after the project is completed and allows a homeowner to borrow against that amount. A bank will send the plans to an appraiser to have the project and property appraised.
The bank will get back an “As Complete Value” or ACV.
How much a homeowner can borrow varies widely depending on the circumstances.
Let’s explore a scenario:
Your home is worth 400K. You want to build an Accessory Dwelling Unit.
You contact an architect and have plans drawn up.
You submit those plans to your bank which sends them to an appraiser. The As Complete Value comes back at 520K, an increase of 120K in value.
You can now borrow up to 95% of the As Complete Value.
The bank then releases funds as certain milestones are achieved and inspected by a third party.
Construction loans are typically short-term with a maximum of one year and have variable rates that move up and down with the prime rate. Two-time close construction loans (as opposed to our one-time close) typically fits this bill. You can also get a one-time close with fixed and adjustable rates.
Sometimes loans provide temporary financing for the project and then it converts to permanent. If this is all done with one application, it’s referred to as a one-close. Others provide a loan for the project and then you must reapply for the permanent financing this would be classified as two-closings.
To Gain Approval, a Lender Will Need:
- Construction plans with a detailed timetable
- Realistic budget
- Proof that you are qualified to borrow and have the means to repay the loan. Like the loans above future rental income cannot be factored in to qualify you for this loan.
Susan mentioned that Umpqua and others have financing available specific to tiny homes (also referred to as ADUs or Accessory Dwelling Units) brought on by a growing interest to meet the immediate need for housing.
Construction loans are most often associated with professional developers and for that reason tend to carry a higher risk. Umpqua, however, doesn’t make loans to developers, only to individual homeowners working with a general contractor, but that’s not always the case. So it’s important to do your own research.
How to Finance with a HomeStyle Renovation Loan in California
This mortgage loan program will help if you have limited equity in your current property, or are purchasing another property that needs improvements that you can finance it into the financing before the work is started.
The HomeStyle Renovation mortgage provides a convenient and flexible way for borrowers considering home improvements to make repairs and renovations with a first mortgage, rather than a second mortgage, home equity line of credit, or other more costly methods of financing.
A single loan for financing the mortgage, repairs & upgrades, based on the As-Completed value of the home.
Renovation costs are limited to 75% of the “As-Completed” appraised value of the home and may include:
- Labor and materials
- Property inspection fees
- Architectural or engineering fees
- Independent consulting fees
- Permit and licenses
- Other documented fees including fees for energy reports, appraisals, review of renovation plans, feasability studies, etc.
How to Finance an Accessory Dwelling Unit in California with a Cash-Out Refinance
This option allows you to refinance your current mortgage for more than you owe and take the difference out in cash. The most common reason for a cash-out refinance is to pay for home improvements.
You have been dutifully making your mortgage payments, accruing equity in the home and paying off your loan. Now, you have equity in the home and still owe 200K on your mortgage.
You decide with low mortgage interest rates to refinance your mortgage for more than you currently owe.
Since you need 100K to finance your project, you refinance your mortgage and take out a new loan of 300K. This allows you cash out 100K.
Should You Do a Cash-Out Refi? This could be a good option if:
- Interest rates have dropped substantially since the last time you financed your home.
- You intend to stay in your home for several more years.
- You have available equity to provide the cash-out option.
- You can shorten your loan term.
It’s important to weigh the benefit of how you’re going to use the money against the amount of time it will take to pay off the loan. For instance, you may be able to get a better interest rate, but it will also extend the number of years needed to pay back your loan. Renting out your granny flat will generate revenue that will allow you to pay your loan off more quickly, but keep in mind that future rental income will not qualify you for a mortgage loan.
Before you do a Cash-out Refi, answer these questions:
- How many years until the end of the term of your current loan?
- How long is the term of the new loan?
- Are interest rates lower than your current financing?
- How much cash do you need?
- What’s the monthly payment amount?
- What’s the effect on your taxes?
- What’s the total cost of borrowing?
- What’s your break-even point
For more information on building an ADU in California contact USModular, Inc.
California Tiny Home