How to finance your ADU project

At Revival Homes, we know that getting financing is one of the most crucial steps of bringing your ADU project to life — but also can be one of the most confusing.

Fortunately, we’re here to help. When you partner with Revival Homes on your ADU project, our experts will recommend multiple financing options based on your needs. Then, we’ll help get you the loan that’s right for your project through our extensive network of partner lenders. 

Before you speak to our team, we encourage you to review our 5 steps to choosing an ADU financing product. Here’s what we’ll discuss:

1. Knowing your loan options

The typical ADU costs over $150,000 to build, which is why most Revival Homes customers get a home loan to finance their project. There are many loan options available, each 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.

Here’s some information on commonly used home financing products:

Home Equity Line of Credit

A HELOC (Home Equity Line of Credit) is a second mortgage that taps your existing home equity for cash. You carry it alongside your existing mortgage — there’s no need to refinance your mortgage. So if you have a low rate on your mortgage, you won’t lose it.

Unlike a fixed-rate home equity loan, a HELOC is a line of credit. It 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 the rate on your HELOC (and therefore, your monthly payment) will rise or fall in the future based on overall interest rates when you draw from your HELOC. 

When It’s Right: HELOCs are a great option for borrowers with high credit scores and lots of home equity (low mortgage balance).

When It Might Not Be a Fit: HELOCs are a less effective option for relatively new homeowners who haven’t yet built up much home equity, or for homeowners who want the certainty of borrowing at today’s interest rate. 

Home Equity Loan

A Home Equity Loan (HEL) is also a second mortgage. Like a HELOC, you carry it alongside your existing mortgage, and it doesn’t require refinancing. However, unlike a HELOC:

• You borrow the full balance of the loan on Day 1, and you pay the loan back in consistent monthly payments (both interest and principal) over 10-30 years.
• HELs are usually fixed-rate loans, which means that the rate stays the same over time regardless of overall interest rates in the economy.

When It’s Right: Like a HELOC, an HEL works well for borrowers with high credit scores and lots of home equity (low mortgage balance). Also, if you want to insulate yourself against possible future interest rate increases, it may make sense to lock in a fixed-rate loan today.

When It Might Not Be a Fit: HELs don’t work as well for homeowners who haven’t yet built up much home equity. Also, homeowners who anticipate falling future interest rates may not want to commit to the HEL rate today.

After-Renovation Value HELOC

An After-Renovation Value HELOC (ARV HELOC) is a type of HELOC that considers your post-renovation home value – the estimated value of your home after you complete your ADU project — when determining your eligibility for a loan and how much you’re qualified to borrow. An ADU can add as much as 40% to your home’s value, and an ARV HELOC will take this into account when the lender underwrites the loan. 

While ARV HELOCs are not a widely offered product, we partner with local credit unions who do provide this product to qualifying borrowers.

When It’s Right: An ARV HELOC is an ideal option for recent homebuyers who haven’t yet built up much home equity, and who have moderate to high credit scores.

When It Might Not Be a Fit: If you have significant home equity already, an ARV HELOC is likely unnecessary relative to more common home loan products, like a standard home equity loan or HELOC.

Cash-out Refinance

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. 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, and the use of funds is flexible — you pay the contractor as key milestones are completed.

When It’s Right: A cash-out refi works well if you have a small mortgage or own your home free and clear, so you’re not concerned about losing an existing low mortgage rate by replacing your old mortgage with a new one that’s set at the current interest rate.

When It Might Not Be a Fit: If you’ve locked in a low interest rate on your mortgage, and your mortgage balance is substantial relative to your home’s value, you’d likely want to avoid a cash-out refi as these loans reset the total balance borrowed to the current market rate. 

Renovation Mortgage

A renovation mortgage 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 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.  

Like an ARV HELOC, renovation loans allow you to borrow based on your home’s forecasted post-renovation value (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 with less-than-perfect credit scores.

When It’s Right: Renovation mortgages work well if you’ve bought your home in the past few years, and you don’t have a low interest rate on an existing mortgage to lose.

When It Might Not Be a Fit: If you have a low-rate mortgage in place, consider second mortgage options instead, like a HELOC or ARV HELOC.

2. Assessing your Personal Financial Situation, Home Value, and Gather Documents

After you familiarize yourself with potential financing options, then it’s wise to examine your personal finances, estimate your home’s value, and think through how these factors impact how much you can borrow for your ADU project. 

When a lender underwrites your loan, they’ll focus on two calculations: loan-to-value (LTV), and debt-to-income (DTI). LTV is used to assess whether the amount of debt on your property falls within a reasonable range, while DTI is used as a measure of your ability to meet your monthly debt payments. 

Loan-to-Value (LTV): LTV is the ratio between a home’s current value and the sum of all debt on the property. So a home worth $1,000,000 today, with a $550,000 outstanding mortgage balance would have an LTV of 55%. Additional loan balances secured by the property, such as a pre-existing drawn HELOC, a home equity loan, or a solar lien would go into the LTV calculation. Most banks are comfortable lending up to 80-90% combined LTV (CLTV) on a first mortgage and/or second mortgage.

Debt-to Income (DTI): DTI is the ratio between your minimum recurring debt payments and your demonstrated income. Lenders use this to assess your ability to responsibly take on additional debt. DTI is calculated by taking the sum of all of your monthly debt payments (e.g. a mortgage, student debt, car payments, etc.) divided by your monthly pre-tax income. Most banks are comfortable lending up to 40-45% DTI.

3. Check Your Credit Score

In addition to LTV and DTI, lenders will check your credit score to assess your financial situation. You can easily check your credit score for free using websites like Nerdwallet or Credit Karma. These services do what’s known as a “soft pull” of your credit score, which doesn’t impact your credit.

Your credit score is important because it’s used as another measure of your likelihood to pay back lenders. Credit scores above 720 are considered very strong, and might make you eligible for lower rates or more advantageous terms from your lender.

4. Identifying the right loan products

Armed with insight into your personal finances, you’re ready to identify which loan product best fits your project. 

If you have higher income and higher home equity (owe less than half of the current market value of your home), it’s likely that a HELOC or home equity loan will meet your ADU project needs.

If you have higher income but lower home equity (for example, if you bought your home within the last 5 years), you might be better suited to an after-renovation value HELOC or renovation mortgage, since these products factor in your home’s likely value after the ADU project is complete. 

If you have a high interest rate on your mortgage or very high home equity (a low or no remaining mortgage balance), a cash-out refinance might be your best bet. This may even give you the opportunity to reduce the interest rate you’re currently paying on your mortgage.

5. Get Quotes From Lenders and Independent Mortgage Brokers

Once you’ve identified a loan product that best meets your needs, you’re in the driver’s seat. At Revival Homes, we’ll work with you to get quotes from our network of partner lenders and independent mortgage brokers, helping you to find the best possible terms for your ADU project. 

We’re here to help you navigate every step of the process, and you can get started with a free consultation with our ADU experts today!