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With housing costs still high and a growing need for multi-generational living solutions, accessory dwelling units (ADUs) are becoming an increasingly popular option for homeowners. An ADU is a separate living space on your property with its own kitchen, bathroom and entrance — essentially a small apartment that can be used for a wide range of purposes, from housing elderly family members to a short-term vacation rental.
However, financing the construction of an ADU may seem out of reach for many homeowners, especially in today’s economy. Not only are interest rates significantly higher than they were a couple of years ago, but persistent inflation is putting pressure on many Americans’ budgets. And, considering that the price of building an ADU currently ranges from $60,000 to $225,000 on average, depending on the size, location and finishes, you may not have the cash on hand to cover the construction costs out of pocket.
But while the cost of building an ADU can be high, there may still be some good options for financing it. For example, homeowners have a total of about $30 trillion in tappable home equity right now, and using that to fund the construction of an ADU or in-law suite could be an option worth considering.
Learn about the top home equity loan rates you may qualify for here.
Can you use your home equity to finance an ADU?
Your home equity can be a source of funding for just about anything, from consolidating high-interest debt to purchasing a second home or making necessary repairs and renovations to your property. That also includes the construction of an ADU, whether the goal is to use the new living space to create new income streams or add flexible living spaces on your property.
Tapping into your equity for this purpose could provide a low-cost solution compared to your other financing options. So, as long as you have sufficient equity available in your home, it’s possible to use that to fund the construction of an ADU — and doing so can be a smart move.
How can you use your home equity to finance an ADU?
You have a few different options when it comes to using your home equity to finance ADU construction. These include:
A home equity loan
A home equity loan uses your home as collateral to secure the loan. This type of funding provides a lump sum loan with a fixed interest rate that is separate from your mortgage, which is why it’s often referred to as a second mortgage.
Home equity loans can be a smart option in today’s rate climate because they allow you to keep your existing mortgage terms. And, since many homeowners secured mortgages with rates near 3% in 2020 and 2021, replacing your current mortgage with a new loan with a much higher rate may not be an attractive option right now.
Explore your top home equity loan options online now.
A home equity line of credit
A home equity line of credit (HELOC) works similarly to a credit card. This type of home equity funding gives you access to a line of credit rather than a lump sum loan, which allows you to draw cash as you need it up to the approved credit limit. It also comes with a variable interest rate and revolving balance during the draw period.
When you’re financing an ADU build, a HELOC can be advantageous because it lets you access funds incrementally as construction progresses rather than getting all the cash upfront as a lump sum. This gives you more flexibility in managing cash flows.
And, the variable-rate nature of a HELOC is also an attractive feature in today’s rate climate. After all, rates are expected to decline at some point in 2024, and borrowers who use HELOCs to fund the construction of their ADU could benefit from these and other potential rate drops in the future.
A cash-out refinance
A cash-out refinance is another option that could be worth considering, but it may not be the best one in today’s rate environment. With a cash-out refinance, you get cash upfront by refinancing into a larger mortgage exceeding your current loan balance. This resets your mortgage rate and terms, so if you currently have a low rate on your mortgage loan, you may want to steer clear of this option for now.
What are the benefits of using home equity to finance an ADU?
There are several compelling benefits to using your home equity to finance an ADU, including:
Simple approval process
Since your home equity itself is used as collateral, the approval process is generally easier than it would be with an unsecured loan.
Affordable financing
These options can also provide much lower rates than alternative financing routes. For example, the average credit card rate is above 21% currently, while the average home equity loan and HELOC rates are currently under 9% across the board.
Boosts property value
Adding an ADU can also significantly increase a property’s market value in most areas. For example, a study by the National Association of Realtors showed that in 2021, homes with ADUs were priced about 35% higher than comparable homes without them.
Income potential
Depending on the market and the local regulations, ADUs can also be used to generate rental income as short- or long-term rental units.
Multi-generational housing
ADUs allow separate living areas for aging parents, adult children or guests.
Tax benefits
Interest paid on a home equity loan or HELOCmay be tax-deductible if you’re using funds to build or renovate the property that secures the loan. So, you may have the option to write off the interest on your home equity loan or HELOC if you use it to build an ADU on your property.
The bottom line
If you’re a homeowner who’s looking to add value, income potential and flexible housing to your property, an accessory dwelling unit can be an excellent investment to consider. By tapping into the equity you’ve built in your home, the financing to construct one can be much more attainable and affordable than other loan options. When coupled with the potentially lower interest rates and possible tax benefits, using home equity for an ADU is certainly worth exploring.
Angelica Leicht is senior editor for Managing Your Money, where she writes and edits articles on a range of personal finance topics. Angelica previously held editing roles at The Simple Dollar, Interest, HousingWire and other financial publications.
