ADU Financing Options in Los Angeles

Homeowners choose to construct ADUs for various reasons including as a substitute for nursing home care, a means to age in community, an opportunity to live with other family members in multi-generational living arrangements, as well as a source of earning extra income to supplement fixed incomes in their retirement years.

If you’re considering an ADU for these or more uses, understanding financing options is crucial. In this guide, we’ll explore how to fund your ADU project in Los Angeles.

Key Considerations For ADU Financing

Source of Funding. 

A Home Equity Line of Credit (HELOC) and other home refinance products, such as cash-out refinances, are available from commercial lenders and credit unions. In a survey of ADU homeowners in Santa Cruz County, CA, over half of the respondents used personal savings and about 40 percent used a HELOC for design and construction. Less than 10 percent used a refinance product. This trend is also seen in Los Angeles. 

Loan Terms.

Financing terms vary depending on loan source. Federal, commercial and non-profit financing sources offer varying packages ranging from:

• Low cost and/or deferred loans. Some financing sources offer low-cost or deferred payment options.
• ADU Loan Assistance: In exchange for providing affordable rental housing, you may receive financial assistance.

Cost-Saving Incentives – Design.

Several cities have implemented incentives for ADU construction such as:

• Free design and project support.
• Pre-Approved Permit Ready Plans: Save up to $30,000 in design and development costs by using pre-approved plans.

Cost-Saving Incentives – Construction

Once design is complete, permit and development fees can also be a deterrent. In order to encourage projects, many cities have:

• Reduced Permit Fees or Fee Waivers: Many cities encourage ADU projects by reducing permit fees.
• Waived Infrastructure Impact Fees: Additional savings can be achieved by waiving infrastructure impact fees.
• Dedicated ADU Permit Review Staff: Streamlined permit review processes facilitate faster approvals.

ADU Financing Loan Options: 

When considering financing options for your ADU project in Los Angeles, homeowners have several choices. Let’s explore the primary loan options available:

First Mortgage

A First Mortgage on the purchase of a new home. The loan is based on the new “as completed” value of the main house. While the loan funds will cover the cost of the home, it likely will not cover the cost of adding a future ADU which would require the homeowner to self-finance with existing cash, credit cards, or to apply for a second mortgage. 

Coverage: While it covers the cost of the home itself, it may not fully cover the expense of adding a future ADU.

Additional Financing: Homeowners may need to self-finance using existing cash, credit cards, or apply for a second mortgage specifically for the ADU.

HELOC

A HELOC or Home Equity Line of Credit is a second mortgage product that provides access to a short-term, variable mortgage that is contingent on the homeowner having sufficient equity to access funds. HELOCs are similar to credit cards in that a homeowner only pays interest as one accesses the funds for construction. Homeowners may refinance the loan on their existing home to access equity due to appreciation in value or a paydown of principal. Proceeds of the refinance could then fund ADU construction.

Equity Requirement: Homeowners must have sufficient equity in their property to access these funds.

Interest Payment: Similar to credit cards, interest is paid only as funds are accessed during construction.

Refinancing Option: Homeowners can refinance their existing home loan to tap into equity due to appreciation or principal paydown, using the proceeds for ADU construction.

Cash On Hand

Homeowners with sufficient cash on hand can use it to pay for the cost of ADU construction and then refinance the home to account for the potential increase in value. Subsequent Refinancing: After completing the ADU, homeowners can refinance their home to account for the potential increase in overall property

Renovation Loans

Renovation loans such as the Department of Housing and Urban Development’s (HUD) 203(k) loans are less widely-used tools that are available to homeowners. The 203(k) product is available for additions to the main structure, meaning the unit must be attached to the main structure via a foundation. Fannie Mae has also recently updated its HomeStyle Loan product for detached ADUs. Homeowners might also consider using loans from retirement accounts such as 401(k) or 403(b) accounts to finance the design and construction of ADUs. 

Assessing Your ADU Financing Options

After completing a budget, the next steps involve engaging with local financial institutions. Here’s what you need to consider:

• Credit Score Requirements: Most lending institutions will require a minimum credit score of 680 for ADU financing. Ensure your credit history is in good standing to meet this requirement.
• Debt-to-Income Ratios: Typically, your total outstanding debt (including the ADU loan) should not exceed 45 percent of your income. Calculate your existing debt and compare it to your income to determine eligibility.
• Expected Income Considerations: Historically, lenders did not consider future expected income (such as ADU rental income) for loan qualification. However, innovative loan products like Fannie Mae’s HomeReady loan now allow capturing expected future rent based on neighborhood comparables and tenant income. Tenants must provide documentation of occupancy over the previous 12-month period.
• Appraisals: Appraisals are crucial for determining the value of your home and assessing the impact of ADU construction. Lenders need to understand the home’s value post-ADU addition.

Home Equity Line of Credit Options

ADU Financing Barriers

Despite the growing popularity and demand for ADUs, many homeowners still face significant challenges in securing adequate financing for their projects. According to a 2022 study by the Terner Center for Housing Innovation, 34 percent of survey respondents cited finding a loan as the biggest obstacle, while 18 percent indicated paying for the cost of construction was their greatest barrier.

To address these financing gaps, some emerging trends and innovative solutions are being explored by various stakeholders, such as developers, public agencies, and philanthropic organizations. Let’s take a look at some of these options:

Additional financing hurdles include:

Debt to income. Individuals are often unable to secure loans that increase their monthly debt to income beyond the 35 to 45 percent threshold. Freddie Mac now accepts income from a signed lease to contribute to one’s monthly income under its Home-Ready program.

Equity. A substantial amount (20% or more in equity) is required for a Home Equity Line of Credit (HELOC) which makes this product unattainable for many low to moderate income property owners.

Credit. A minimum credit score of 680 is necessary to qualify for Fannie Mae guaranteed loan products. 

Filling the ADU Financing Gaps

Despite the growing popularity and demand for ADUs, many homeowners still face significant challenges in securing adequate financing for their projects. To address these financing gaps, some emerging trends and innovative solutions are being explored by various stakeholders, such as developers, public agencies, and philanthropic organizations. 

Emerging Financing Trends

Seller Financing / Developer

• Description: An emerging model for ADU construction is one where a developer owns the ADU, while the property owner owns the land. The developer pays the homeowner a percentage of the rental revenue each month under a lease agreement.
• Advantages: The developer is responsible for all construction, installation, and maintenance costs. The property owner has the choice of identifying qualified tenants for the ADU, but can also allow the developer to select tenants and guarantee a minimum monthly payment. The property owner can purchase the ADU at any time based on a declining buyout payment established in the lease agreement. At the end of the lease term, the property owner will own the unit outright.
• Example: A company called United Dwelling offers this model in Los Angeles, where they design, build, and manage ADUs on homeowners’ properties. They share 50 percent of the rental income with the homeowners and offer a buyout option after five years.

Public or Philanthropic Grant or Soft Loans

• Description: Public grants or soft loans are financial assistance programs offered by public agencies or philanthropic organizations to encourage ADU development, especially for low- to moderate-income homeowners or affordable housing purposes.
• Advantages: These programs can provide low-cost or deferred loans, grants, or subsidies for ADU planning, design, or construction. They may also offer technical assistance or streamlined permitting processes.
• Example: In Los Angeles County, the ADU Accelerator Program provides financial incentives and support to homeowners who are willing to rent their ADUs to older adults facing housing insecurity. The program offers up to $50,000 in forgivable loans for ADU construction or renovation, as well as rental subsidies, tenant case management, and landlord support.

Policy Recommendations

As ADUs become more popular and accessible, there are still some challenges and barriers that prevent low-income seniors from realizing the ADU opportunity. To address these issues, local jurisdictions can take a number of steps to help them finance and build ADUs on their properties. These include:

• Partnerships with Local Foundations: Local jurisdictions can partner with local foundations to provide seed funding to local non-profit design, construction, and development organizations that specialize in ADUs. These organizations can offer low-cost or pro-bono services to low-income seniors who want to build ADUs on their properties.
• Forgivable Pre-Development Loans: Local jurisdictions can provide forgivable pre-development loans to homeowners that can be used for pre-construction activities such as inspections, feasibility assessment, and project management services. These loans can be forgiven if the homeowner agrees to rent the ADU to a low-income senior or another eligible tenant for a certain period of time.
• Grants for Loan Loss Reserve or Credit Enhancement: Local jurisdictions can provide grants to establish a loan loss reserve or other credit enhancement to induce credit unions or other lenders to loosen credit terms for homeowners who want to build ADUs. This can help homeowners who have low credit scores, high debt-to-income ratios, or insufficient equity to qualify for traditional loans.
• Consumer Financing for ADU Development: Local jurisdictions can offer consumer financing for ADU development that would include short-term financing that could be convertible to long-term shared appreciation financing. This means that the homeowner would pay back the loan based on a percentage of the increased value of the property due to the ADU addition, rather than a fixed interest rate. This can help homeowners who have limited cash flow or income to afford the monthly payments.
• Local Loan Pools: Local jurisdictions can create or participate in local loan pools that can provide below-market loans to income-eligible homeowners for ADU construction. These loan pools can be funded by private sources, such as banks, philanthropic organizations, or impact investors, who are interested in supporting ADU development as a way of increasing affordable housing supply and creating social impact. These loan pools can offer special below-market purchase and rehab loans to home-buyers and homeowners who want to build ADUs on their properties.

Case Studies

Let’s look at some examples of how these policy recommendations have been implemented or proposed in Los Angeles or California:

Los Angeles County: The county has partnered with non-profit organizations like LA-Más to provide design and construction services for ADUs for low-income homeowners who agree to house Section 8 voucher holders. The county also provides a $75,000 forgivable loan to cover the cost of the ADU, which is forgiven after five years of renting to a Section 8 tenant.

San Jose: The city has proposed a pilot program to provide $100,000 loans to low-income homeowners who want to build ADUs on their properties. The loans would be repaid through a shared appreciation model, where the homeowner would pay back a percentage of the increased value of the property due to the ADU addition. The city would also provide technical assistance and streamlined permitting for the ADU projects.

San Diego: The city has created a Housing Trust Fund that provides low-interest loans and grants to nonprofit developers and homeowners who want to build ADUs for low-income households. The fund also supports the development of pre-approved ADU plans and a permit-ready program to reduce design and permitting costs.

Remember, ADUs are a great opportunity for low-income seniors to create additional living space, income, and security on their properties. However, they may need some assistance and support from local jurisdictions to overcome the financing and regulatory barriers. If you need more information or guidance on ADU policies and programs, feel free to contact Yifu Design Studio.

Resources

Building an ADU requires much of the same research, contemplation, and preparation as making any other large financial investment. Families should assess their needs and finances to determine whether building an ADU makes good financial sense.

Financing an ADU can be challenging, but not impossible. There are various options and resources available to help you fund your ADU project. You’ll want to research and compare different ADU financing options, apply for cost-saving incentives, and explore emerging financing trends. If you need more guidance or assistance, feel free to contact Yifu Design Studio. We’re here to help you design and build your dream ADU in Los Angeles. 

• Los Angeles County Department of Regional Planning. (2022). Appendix IV Step-by-Step Guide for Accessory Dwelling Units (ADUs) in Unincorporated Los Angeles County
• City of Los Angeles. (n.d.). Homeowners | ADU
• Dwellito. (n.d.). Guide to getting an ADU in Los Angeles
• HOMEPLEX. (n.d.). California ADU Financing: How to Finance an ADU

“Even with the provision of user guides, technical assistance, and financing, older adults are reluctant to take on any additional debt and are unwilling to manage the construction process even though they were prime candidates for ADUs. With this in mind, new financing programs administered by a jurisdiction will require a concerted educational outreach effort to older adults and their families to achieve success.

Karen Chapple. 

Professor, UC Berkeley