ADU guide: What is an ADU? Rules and financing options

Paul Centopani
Paul Centopani
The Mortgage Reports Editor
August 9, 2022 - 7 min read

The rise of accessory dwelling units

Granny flats, in-law apartments, backyard cottages, carriage houses…no matter what you call them, accessory dwelling units (ADUs) can provide more living space or an additional revenue stream.

They can also help with the ongoing shortage of available and affordable housing supply — especially in densely populated cities where land is limited.

But building an ADU is different from a house and comes with its own set of rules and restrictions. Before diving in, it’s important to know your local zoning regulations, which loan types are best, and if you’re eligible for a $40,000 ADU grant.


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What is an ADU?

Accessory dwelling units (ADUs) are a secondary type of housing structure on a property that already has a house on it. They have to have a separate entrance, kitchen, bathroom, and living space from the main home.

ADUs come in different forms, such as garage conversions, standalone structures in the backyard, or an attachment or converted part of the existing house.

Families often leverage ADUs to create separate, multigenerational living solutions on a singular property while also providing autonomy. They can also be rented out as an additional source of income for homeowners.

“The most common use is by house hackers or more savvy investors looking to create continual revenue streams from a primary residence,” said Kerron Stokes, president and co-founder of Resource Group at RE/MAX Leaders. “ADUs address many additional issues including security, privacy, use of lot space, and income based on resident occupancy. This has become a big one for many cities that have restricted AirBnB.”

Where can ADUs be built?

California and Oregon are the only two states to have blanket ADU legalization on any residentially zoned property as of July 2022. New York is working to pass the same statewide bills as California.

“We’ve seen more than 50 major metropolitan cities passing ADU ordinances as a way to try to alleviate some of the burden of buying a home. Typically cities that are growing rapidly and having affordability issues.”

-Caitlin Bigelow, CEO and co-founder of Maxable

“Beyond those, it’s going to depend on the local jurisdiction that you live in. There are fantastic ADU ordinances in Austin, Houston, and San Antonio, Texas. There are some great ordinances within Colorado, but it’s all going to be dictated by the local level,” said Caitlin Bigelow, CEO and co-founder of Maxable, an ADU marketplace and data provider.

“We’ve seen more than 50 major metropolitan cities passing ADU ordinances as a way to try to alleviate some of the burden of buying a home. Typically cities that are growing rapidly and having affordability issues.”

How can I find my local ADU ordinance?

If where you live allows ADU construction and wants them to happen, the rules around them should be relatively easy to find. The best way is to search your city’s website, according to Bigelow.

Typically, it’s a good sign if there’s an ADU summary on the site. But if you end up digging through hundreds of pages of municipal code, that probably indicates that your locale isn’t ADU-friendly.

“Zoning and rising construction costs are the primary challenges to ADUs,” Stokes said. “Consumers need to do thorough due diligence when considering a property for this use. Height requirements, utilities, construction codes, easements and tax zones can ultimately impact the construction and use of the property.”

How to finance an ADU

ADU lending options differ from normal home loans since they aren’t intended to be a primary residence. Although, the choices borrowers make still similarly depend on the interest rate environment.

Overall, about 60% of borrowers paid for their ADU using liquid assets and around 40% used a mortgage, according to a 2021 UC Berkeley Terner Center for Housing Innovation survey of over 800 California homeowners. Using cash is more common because ADUs are often made for older family members who may have just sold their homes and are pooling their money together.

Among those who took out a mortgage, 56% went with a HELOC or home equity loan, 35% did a cash-out refinance and 6% took out a renovation or construction loan.

ADU Mortgage Type% of Homeowners (CA)
HELOC/Home equity loan56%
Cash-out refinance35%
Renovation or construction loan6%

“When we saw historically low interest rates last year and the year before, everyone was doing a cash-out refinance. Now, people are much more inclined to do a HELOC because they don’t want to touch their existing interest rates,” Bigelow said.

“The other method is through renovation loans, which are not a great option if you don’t want to touch your primary mortgage. I don’t see those being super popular this year, they really were only a good choice if you didn’t have any equity to start with. And the last option is people can pay cash.”

Fannie Mae and Freddie Mac’s new ADU rule

A major development for ADUs comes at the federal level. Fannie Mae and Freddie Mac now allow homeowners to qualify for a loan based on their future projected ADU rental income.

Previously, you couldn’t use any potential ADU income for mortgage qualification — even if you did your homework and based the hypothetical monthly rent on market comps.

“The types of people that were building ADUs tended to either have a lot of home equity or they had cash they could draw on,” Bigelow said. “With this new program rolling out, there’s going to be a whole new subset of borrowers that wouldn’t have previously qualified for a loan that will now because the rental income can be counted.”


ADU grant programs

Before looking into financial options for your ADU, you should see if your area offers any grant programs. These programs can be found in several cities around the country and could be popping up in many more as an incentive to bolster housing stock.

In 2022, the California Housing Finance Agency announced a $100 million budget for individual ADU grants of $40,000 for residents. You do need to come in below the income qualifications but they are pretty high. In Santa Clara County, for example, you can make up to $300,000 a year and still qualify.

“It’s not a loan. It doesn’t have to be paid back. It’s literally free money. That $40,000 can go toward any soft costs for the project,” Bigelow said. “It could go to design and permit fees. And if your design and permit fees don’t exceed $40,000, which most of them probably won’t, then the rest of that grant can be used to pay down the interest rate on whatever loan you took out. We’re really excited about the potential this opens up for people.”

Can ADUs help the inventory crunch?

Perhaps the largest issue facing the U.S. housing market is the ongoing lack of homes for sale. The supply and demand imbalance caused by low inventory is the main driver of the surging home prices we saw over the past two years.

While ADUs won’t solve the problem, upping their numbers and making their construction more accessible would certainly help.

“ADUs are not going to be the silver bullet that solves our housing crisis. But they’re one of the most viable ways we can increase housing stock.”

-Caitlin Bigelow, CEO and co-founder of Maxable

“ADUs are not going to be the silver bullet that solves our housing crisis. But they’re one of the most viable ways we can increase housing stock,” Bigelow said. “But housing policy in general is highly, highly controversial. And when you see the state attempt to get involved and try to push legislation that would be able to increase density to really alleviate the housing crisis, those bills are almost unanimously shot down.”

But as the new Fannie Mae rule may indicate, the tide appears to be slowly turning in favor of ADU policies at the federal level.

On Feb. 1, the White House held its first conference on how to promote ADU growth nationwide. Susan Rice, the Biden Administration’s domestic policy advisor, said she believes ADUs are the best way to boost the current U.S. housing stock.

California’s ADU model

The Golden State is home to some of the least affordable, most densely populated, and most desirable housing markets in the country. These factors also make it a place in dire need of more available housing.

California passed multiple laws loosening ADU rules in order to make building them easier and faster. Since 2017, the state passed six bills to streamline ADU construction and remedy common hurdles borrowers faced.

“The state has done away with owner-occupancy [requirements]. The state has done away with minimum lot size requirements. They mandated a maximum four-foot side and rear setback,” Bigelow said.

“ADUs now legally have to be prohibited in HOAs, so it overrules any of the local CC&Rs [covenants, conditions, and restrictions] within a neighborhood. And they eliminated development and impact fees. As a result, more than 20,000 ADUs were built over the last few years in response to these changing regulations within California.”

From 2018 to 2020, a total of 33,881 ADUs were permitted to be built and 22,695 were completed in California, according to the California Department of Housing and Community Development.

YearADUs PermittedADUs Built
20188,9575,930
201912,5327,808
202012,3928,957

ADU advice for borrowers

If you’re considering building an ADU, the first step is to figure out whether it makes sense for you financially.

If you’re building one to rent out, that doesn’t necessarily mean only looking at upfront costs but also what your monthly cash flow would be, Bigelow advised. For example, if you finance an ADU for $100,000 and have monthly loan payments of $600, estimate how much a modern studio would rent for in your neighborhood.

“In most of California, you can get anywhere from $1,200 to $3,000 per month for that. While the upfront price point can be scary, the financial benefits are very, very compelling,” Bigelow said.

She also encourages homeowners to explore your contractor and designer options before hiring anyone.

What are today’s mortgage rates?

If you’re ready to break ground and add more living space on your property, great! Your next step is to explore local ADU laws and the best way to finance one — even if you plan on paying for it in cash.

As always, reach out to your real estate or lending professional with any questions and to see what interest rates you qualify for.


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