What Is the Best Way to Pay for an Accessory Dwelling Unit (ADU)?

Quick Answer

To finance an accessory dwelling unit (ADU), consider options such as tapping into your home equity, applying for a home construction or renovation loan, borrowing from family or searching for government and nonprofit grants in your area.

Small house in backyard with lawn and stone path

Whether dubbed "granny flats," in-law apartments or backyard cottages, building an accessory dwelling unit (ADU) is becoming a popular choice for homeowners who have the space. An ADU can add value to your home, house extended family and generate passive income as a rental.

An ADU is a self-contained residential living space built on the same lot as a detached single-family home. It can be separate from the main home or attached (such as a basement). An ADU can be built from scratch, from a kit or by converting an existing structure, such as a garage. The ADU must have its own entrance, kitchen and bathroom.

Some homeowners use ADUs to house aging parents or other family members. Others rent them to tenants or use them as vacation rentals for extra income. No matter your intention, here's how to finance an ADU.

How Much Does It Cost to Build an ADU?

Local zoning ordinances governing ADUs can greatly affect your costs. For example, you might have to provide a certain number of parking spaces or comply with specific design criteria so the ADU blends in with the neighborhood.

Other costs may include:

  • Variances: If local zoning laws forbid ADUs, you can apply for a variance with the zoning authority. This typically involves a filing fee and possibly hiring an attorney.
  • Building and land use permits: If the project isn't properly permitted, the city might shut down construction or force you to tear down and start over. The cost of permits will typically be a small fraction of the overall project cost.
  • Design, architecture and engineering: Architecture or engineering plans are usually required to get building permits.
  • Electricity and plumbing: Installing utility connections typically costs more for a stand-alone structure than an attached ADU.
  • Building contractor: Unless you plan to do it yourself, you'll need a general contractor to manage the project.
  • Materials: Inflation, supply shortages and the use of high-end materials can substantially increase an ADU's cost.

To reduce the cost of building an ADU:

  • Work with a contractor who specializes in building ADUs
  • Choose more affordable building materials
  • Buy a prefabricated unit
  • Modify an existing structure instead of building from the ground up
  • Construct an internal ADU within the walls of your existing home instead of a free-standing structure

How Can You Finance an ADU?

Most homeowners (62%) who build ADUs finance them with savings or other liquid assets, according to a 2021 study by the University of California, Berkeley, and the University of Southern California. Another 43% finance ADUs with mortgages; of those, 56% use home equity loans or home equity lines of credit (HELOCs), 35% use a cash-out refinance and 6% use construction loans. Here's a closer look at these and other options:

  • Cash-out refinance: You pay off your existing mortgage with a new one for the amount of your original mortgage plus extra money to use for your ADU. The extra amount you can borrow is typically limited to 80% of your home equity. Cash-out refinancing may not make sense when mortgage interest rates are high. Assuming your current mortgage interest rate is lower than today's rates, a second mortgage could be a better option.
  • Home equity loan: These generally allow you to borrow up to 85% of your home's equity as a lump sum and pay it back in monthly installments at a fixed interest rate.
  • Home equity line of credit (HELOC): HELOCs provide a credit line of up to 85% of the equity in your home. Similar to a credit card, you draw down the line of credit as needed and pay back only what you use, typically at a variable interest rate. Second mortgage options, including home equity loans and HELOCS, use your home as collateral, which could put your home at risk if you fail to repay the loan.
  • Home construction loan: These loans pay out money to the builder (not the borrower) in stages. Because the home isn't built yet and can't serve as collateral, home construction loans usually have higher interest rates and require better credit scores than mortgage loans. During construction, you make payments only toward interest. Between six and 24 months after getting the loan, you must either pay back the full amount or get a mortgage to cover it.
  • A renovation loan: This type of home construction loan allows you to borrow against your home's estimated value after renovation.
  • Reverse mortgage: Homeowners ages 62 and up can use a reverse mortgage to borrow against their home equity. You don't make monthly payments; instead, the lender recoups their money from your equity if you move, die or fail to meet other conditions. A line of credit or lump sum from a reverse mortgage could finance an ADU, but clarify any limitations on what the loan can be used for before you apply.
  • Borrowing or receiving gifts from family and friends: You can get a loan or gift from a family member, such as the person who will live in the unit.
  • Government or nonprofit programs: Some locales and nonprofits offer assistance including grants; low-interest, forgivable or deferred loans; waived or reduced permitting fees and more. Typically, such programs require renting the ADU to low-income tenants or at below-market rates for a certain period. Search online or contact local housing authorities for programs in your area.

What Value Does an ADU Have?

ADUs offer a wide range of financial benefits.

  • Increased home value: By one estimate, a $100,000 garage conversion can add $1.5 million or more to a home's value over 30 years, considering both rental income and higher property values. That's a 1,500% return on investment. A 2021 analysis by Porch.com found that in major cities, homes with ADUs list for an average of 35% more than those without them. These figures can vary greatly by your local real estate market, however.
  • Passive income: Renting out your ADU, either long term or short term, can mean significant income. In Los Angeles, for instance, a studio apartment rents for an average of $2,082 and a one-bedroom for $2,300 per month, according to RentHop. Use this extra income for living expenses, repaying the ADU loan or saving for retirement and other goals.
  • Saving money: Housing aging parents at home, where you can help care for them, can be substantially cheaper than assisted living, which costs an average of $4,500 per month, or home aides, which average $5,148 per month, according to Genworth's Cost of Care Survey. You could also let your adult children live in your ADU while they save for a down payment on their own home. Out-of-town guests could stay with you in your ADU instead of at a hotel.
  • Home office: Subject to local zoning laws, professionals such as massage therapists or accountants can use ADUs as home offices. Clients can visit without intruding on your home, and you won't have rising office rents or costly commutes to worry about.

Balance these benefits against ongoing costs including:

  • Utility bills: Unless you charge tenants for utilities, you'll have higher utility costs.
  • Homeowners insurance premiums: Adding square footage or adding a free-standing structure to your home generally increases your home insurance costs.
  • Maintenance and repairs: Just like your primary home, an ADU requires factoring ongoing care and maintenance into your budget.
  • Property taxes: Generally, building an ADU won't prompt a reassessment of your primary home's value, but you will pay additional property taxes on the ADU.
  • Income taxes: If you plan to rent out the unit, you may have to pay taxes on the rental income.

Building for the Future

No matter how you decide to finance an ADU, getting your credit in shape can help you qualify for lower interest rates and better terms. Check your credit report and then work to boost your credit score by reducing credit card debt, paying bills on time and not applying for new credit.