HELOC vs. Home Equity Loan vs. Refinance: What's the Best Way to Finance an ADU?

If you've owned a California home for several years, the answer to financing your ADU may be sitting underneath your feet.

It's your home equity.

For homeowners with substantial equity, three financing options frequently come up when considering an ADU:

A HELOC, a home equity loan or a cash-out refinance.

All three can turn home equity into money that can potentially be used to build an ADU. But they work very differently.

Choosing between them can have a significant effect on your monthly payment and the ultimate cost of your ADU.

First, How Much Home Equity Do You Have?

Home equity is essentially the difference between the value of your property and the debt secured by it.

For example, suppose:

Estimated home value: $1,500,000
Existing mortgage: $600,000

That homeowner has approximately $900,000 in gross equity.

That does not mean a lender will allow the homeowner to borrow the entire $900,000. Lenders establish maximum loan-to-value or combined loan-to-value limits and also evaluate income, credit and other underwriting requirements.

But substantial equity can create financing options that a homeowner without equity may not have.

Option 1: HELOC for an ADU

A Home Equity Line of Credit, or HELOC, creates a revolving credit line secured by your home.

For ADU construction, the draw structure can be particularly useful.

Imagine your ADU costs $250,000.

You don't necessarily need all $250,000 on the first day. Design, permits, site work and construction happen at different stages.

With a HELOC, you may be able to draw funds as they're required.

That can make the HELOC a natural match for construction cash flow.

A HELOC may make sense when:

• You have substantial equity
• You want to preserve your existing mortgage
• You want flexibility in when you borrow
• Your construction expenses will occur over several months

The major consideration: variable rates

HELOC rates are commonly variable.

That means the cost of your ADU financing can increase or decrease as interest rates change.

A homeowner should therefore evaluate the HELOC not only at today's rate but also consider what the payment could look like if rates rise.

Option 2: Home Equity Loan for an ADU

A home equity loan is also secured by the equity in your home, but instead of a revolving credit line, you generally borrow a specific amount.

This can make budgeting easier.

If your ADU contract and project costs are well defined, receiving the money as a lump sum with a predictable repayment schedule may be attractive.

A home equity loan may make sense when:

• Your ADU budget is well established
• You want predictable payments
• You prefer a fixed-rate structure when available
• You want to leave your existing first mortgage untouched

For homeowners who already have an attractive first-mortgage rate, that last point can be especially important.

Option 3: Cash-Out Refinance for an ADU

A cash-out refinance works differently.

Rather than adding a second loan, you replace your existing mortgage with a larger new mortgage.

The difference becomes cash that can potentially fund your ADU.

This can simplify your financing into a single mortgage.

But there's a potentially significant downside.

You are refinancing the entire existing mortgage, not simply the money needed for the ADU.

Consider someone who owes $600,000 on a mortgage with a particularly low fixed rate.

If that homeowner only needs $250,000 for an ADU, refinancing the entire $600,000 balance plus the additional cash at a higher current rate may be considerably more expensive than leaving the original mortgage alone.

This became a real obstacle to ADU financing when mortgage rates increased. CalHFA reported that traditional construction and renovation financing became less attractive to homeowners because it often required refinancing historically low-rate first mortgages.

HELOC vs. Home Equity Loan vs. Cash-Out Refinance

Here's the simplest way to think about the three options:

The right answer depends on the actual terms offered to you.

Don't Compare Interest Rates Alone

This is one of the biggest mistakes homeowners can make when looking for an ADU loan.

Suppose your existing mortgage is at a favorable fixed rate.

A cash-out refinance might advertise a lower rate than a HELOC, but the new rate applies to the entire refinanced mortgage balance.

The HELOC rate might be higher, but it applies only to the money you've borrowed through the line.

You need to compare total borrowing costs, not simply the advertised interest rates.

Could the ADU Help Pay for Its Own Financing?

Now add rental income to the analysis.

Suppose your completed ADU could rent for $3,000 per month.

That's potentially $36,000 per year in gross rental income before vacancy and expenses.

If you're borrowing money to construct the ADU, compare the annual financing cost with potential net rental income.

Metricon's ADU Rental Return Calculator allows you to enter:

• Construction cost
• Loan-to-value
• Interest rate
• Financing costs
• Monthly rent
• Vacancy
• Property taxes
• Insurance

It then estimates metrics including net operating income, financing costs and potential cash-on-cash return.

That's a more useful way to think about an income-producing ADU than simply asking, "What will my loan payment be?"

What About the Value the ADU Adds to Your Property?

Rental income is only one side of the equation.

You're also adding another permitted dwelling to your property.

That may increase the property's market value, although the actual increase depends on the property, location, ADU size, configuration and local real estate market.

Metricon's financing tools therefore also include an ADU Value & Tax Calculator and a Property Appreciation Return Calculator.

Together, these tools allow homeowners to consider three separate financial effects:

• What does the ADU cost to finance?
• What income might it generate?
• What value might it add to the property?

That's the analysis we believe homeowners should make before deciding whether, and how, to finance an ADU.

So What's the Best ADU Financing Option?

There isn't one answer for every homeowner.

If you have substantial equity and a very low first-mortgage rate, preserving that mortgage through a HELOC or home equity loan may deserve serious consideration.

If your existing mortgage rate isn't particularly attractive, refinancing may be more competitive.

If you don't have enough accessible equity, an ADU construction or renovation loan may be worth investigating.

The important thing is to compare the options before committing to a construction project.

Run the Numbers on Your ADU

Before deciding how to finance your ADU, use Metricon Homes' ADU finance calculator to model the project.

Estimate your financing costs. Look at potential rent. Consider property taxes and insurance. Estimate the value the finished ADU could create.

Then speak with a qualified lender about the financing products and terms actually available to you.

A well-financed ADU shouldn't simply add space to your property. It should make financial sense as well.