How Can You Pay for an Accessory Dwelling Unit (ADU)?

This is the third installment of a monthly series about one of the hottest topics in real estate: Accessory Dwelling Units.

ADUs have gotten a lot of attention recently as a housing option. You can read the previous installments on this blog. My thanks to John Phillips of Verdant Living for helping with the research on this series of articles.

ADUs — detached accessory (or additional) dwelling units, also called mini homes — are a wonderful idea for the right homeowner. They use an existing piece of residential real estate and create a separate living space. They are often used for intergenerational housing (aging parents, 20-somethings just starting out, etc.) and have long-term value as rental property and add to the value of your real estate.

So, you want to put an ADU on your property. How do you pay for it?

A couple of basics. First, an ADU is part of an existing piece of real estate (a primary residence). As a result, assuming money is borrowed to pay for it, the loan will be within the mortgage finance industry. Until recently, very few in that industry were knowledgeable about ADUs, much less about how they could be financed. Banks, other lending institutions, mortgage brokers, government finance authorities, didn’t understand how they fit in, but that is changing. Second, the amount of the loan will be relatively significant, far more than purchasing a nice automobile, or a home improvement loan. It will probably be one of the largest loans the borrower has, exceeded only by the mortgage on their primary residence.

In my “Real Estate Today” column on February 20, 2025, posted in this blog, I discussed the basics of ADU finance. Today, I want to talk a bit more about the dynamics involved.

Financial issues are an impediment to getting an ADU built because of two general issues.

Credit Qualification. As anyone who has purchased a home knows, the mortgage industry has an extensive process to determine the credit worthiness of a borrower for a particular transaction (income, debt-to-income ratio, credit score, etc.). This is one of the reasons the majority of ADUs are built by relatively well-off homeowners. For those of moderate means, financing the construction can be a challenge. This is unfortunate, because those are the homeowners who might benefit most having an ADU for intergenerational housing and, in the long term, creating rental income and building wealth by enhancing the value of their most valuable asset, their home. If a homeowner has a real need, and is determined to build the ADU, here are some practical suggestions that might improve credit worthiness:

> Lower the amount of the loan and thus the monthly payment by increasing the down payment, using available cash (savings or whatever) or with help from parents/children/friends.

> Have a friend or relative co-sign for the loan (a solution that could involve sharing ownership of the real estate).

> Consider ways to show the lender the value of the ADU. A rental agreement with the tenant who will occupy the ADU, explain the ongoing rental value, or show how the ADU will increase the value of the real estate (thus increase the value of the mortgage security). Note, this sort of thing is just now being taken into account by the mortgage industry.

> In Colorado, legislation supporting ADU development (which takes effect this July) includes a provision (and some funding), tasking the Colorado Housing and Finance Authority (CFHA) with organizing a program that would help ADU purchasers of moderate means qualify for financing. That program should be announced soon.

> Lower the cost of the ADU by choosing lower cost options, ranging from less expensive building materials to things like more affordable appliances.

Borrower reluctance. It should come as no surprise that interest rates play a major role. Homeowners can use the equity in their main residence (by refinancing their current mortgage) to build the ADU. However, if the primary mortgage carries a low interest rate, as most do these days, the borrower will not want to refinance at current rates.

A good alternative is to apply for a home equity line of credit (HELOC) to pay for the ADU and leave the primary mortgage in place; the result would be a “blended” interest rate that may be more palatable. In addition, there is an emotional issue, which may be present in buyers of moderate means. Taking on substantially more long-term debt can be intimidating. The “need” has to overcome the understandable reluctance.

Finally, there is the possibility of a third party (someone not living on the property) investing in the ADU, thus facilitating the financial piece. Under recent legislation the legal mechanisms to make it work would need to be developed. It is an interesting possibility and could overcome the financing obstacles, particularly for those of moderate means.

Although the dynamics are very different, a similar idea has been tried in South Africa to help ease the need for housing there. Here’s a link to a Bloomberg article about that project.

To help with these issues, Verdant Living has published a very useful buyers guide, BuyersGuideColoradoADUs.com, with advice on financing. Another good resource is the VerdantLiving.us, or contact John Phillips at 303-717-1962.

I want to thank the following people in addition to John Phillips for their input: Jaxzann Riggs, The Mortgage Network; Kristen Stultz, Macro Financial; Charles Edington, LOANstar; Cindy Beier, Cindy’s Property Solutions.

Next month: Why smaller living spaces work well