Want to Add a Granny Flat or Rental ADU? Here’s How to Finance It

ADUs are going mainstream. An ADU (accessory dwelling unit) is an independent living space sharing the same lot as a single-family house. Depending on the structure and the local slang, you might know it as a granny flat, carriage house, garage or basement apartment, backyard cottage, tiny house or something quirkier.

The federal government, and some states and localities, are encouraging homeowners to build ADUs to ease shortages of affordable housing. The mortgage industry is becoming more ADU-friendly, too. If you want to add an ADU to your existing home, there’s probably a loan program that suits your needs.

Before you shop lenders and contractors, you’ll need to decide what kind of ADU you want, and why you want to build it. Those factors will shape which type of loan you’ll be eligible for.

The Fannie Mae requirements for an ADU include its own entrance, a kitchen with a sink and stove, a place to sleep, and a bathroom. The ADU has to be smaller than the primary house. Check local laws for requirements and limitations regarding things like parking spaces, utility hookups and emergency exits. But with those conditions satisfied, an ADU can take the form of:

• An addition to the house.

• A conversion of an existing space, such as a garage, basement or attic.

• A “stick-built” (constructed on-site from the ground up) structure in the backyard.

• A modular or manufactured home placed in the yard.

• An addition (such as an added second story) to a detached garage.

Financing options are similar whether you build something new or convert existing space.

“A growing number of local and a handful of state laws have made it easier to build ADUs,” said Ellie Sheild, an urban planner and graduate student research assistant at Harvard University’s Joint Center for Housing Studies. She made her remarks in October as lead author of a research paper with David Luberoff.

Sheild said one important change has been adoption in some places of “by-right approval,” meaning the city can’t block construction of your ADU because neighbors don’t want one next door.

Many homeowners add ADUs to collect a rent check every month. But plenty of folks are ADU-curious because they literally want to move Granny into a granny flat.

“Instead of sending them to a nursing home or assisted living, which can cost tens of thousands of dollars a month, why not put that money in investing in building an ADU on your own property and having your parents and loved ones close by?” says Sherry Chen, a real estate agent with Kappel Realty Group in San Diego who specializes in homes with ADUs.

Sometimes the generations are switched around, says Will Johnson, a construction loan broker in San Diego who specializes in ADU financing for Ridge Capital Group. He says parents in uber-expensive Southern California frequently house their adult offspring in ADUs. Living in a snug ADU gives them space to save for a down payment.

Few of us can afford to draw from savings and pay cash to create 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? If so, you might be able to count a portion of the tenant’s rent payments as income when you apply for a loan. It depends on the loan program and may include factors such as whether you’ve been a landlord before.

And if you don’t plan to collect rent on the ADU, that’s fine. It’s not like lenders will penalize you for being insufficiently capitalist. You’ll qualify for the loan based on your current income. And probably have fewer papers to sign.

In the initial talk with a client, Johnson says the first thing he asks is how much equity the homeowner has. Then he asks whether the owner refinanced when mortgage rates were low. If the client has enough equity and has a low-rate mortgage that they want to keep, borrowing equity is the way to go.

The main advantage to borrowing equity is that you keep your low-rate primary mortgage.

There are two big disadvantages. First, interest rates on equity products tend to be higher than rates on first-lien mortgages. Second, you can’t borrow as much as you can with a construction loan or renovation loan.

That’s because most equity loans and HELOCs limit you to owing 80% of the home’s current value when you combine the mortgage with the equity debt. If that doesn’t raise enough to pay for the project, you’ll have to dip into savings.

When borrowing from equity would be insufficient, the next option is to replace your current mortgage with a construction loan or renovation loan.

These mortgages have an advantage over borrowing from equity: They let you borrow more. That’s because the loan amount is based on the projected value of your property after the ADU is ready for occupancy. In contrast, the amount you can borrow in an equity loan or HELOC is based on the home’s value before the work is done.

In today’s rate environment, the main disadvantage to refinancing into a construction or renovation loan is that you give up a low mortgage rate and accept a higher one. You might end up with a much bigger monthly payment.

Many people catch the notion to add an ADU and they contact a contractor first, Johnson says. Contractors can be a source of lender referrals.

For example, Johnson has relationships with contractors who refer customers to him early in the process so he can determine whether they can get sufficient financing.

Or you might work it the other way: Contact a mortgage lender who you’re familiar with and ask for a referral to a contractor.