An accessory dwelling unit (ADU) can give homeowners more space and a new income stream.

An accessory dwelling unit (or ADU) is a smaller, independent residence on the same lot as a single-family home.

Also known as granny flats, backyard tiny homes or in-law suites, ADUs are a growing trend in home building and renovation. They're cheaper to build than single-family homes and can be part of or attached to an existing property or stand alone.

ADUs are providing a cost-effective solution to the nationwide housing shortage and can significantly enhance your property value while providing space for renters, guests or family members.

An ADU is a separate housing unit built by a homeowner on their property. These homes typically range from 500 to 1,200 feet and can be attached or detached from the main house.

ADUs have become increasingly popular as local and state governments have addressed housing shortages by relaxing regulations regarding construction on residential lots. This is especially true in California: Since 2019, new state laws have allowed homeowners to build ADUs up to 1,200 square feet, regardless of local ordinances. The state also established ADU grant programs to encourage their development.

Connecticut, New York, Maine, Oregon and Washington have also eased regulations on ADUs, as have cities like Austin, Denver and Phoenix.

Accessory dwelling units have a lot of potential:

• Rental units: The additional income from renting out an ADU can help you recoup the cost of the build and provide extra cash once you pay it off.
• Multigenerational living: ADUs can be a solution for families both priced out of the housing market and retirees who can't keep up with the costs of maintaining a house.
• Guest houses: Even if you use an ADU as a place for friends to stay over, the addition can boost your property value when you decide to sell.

There are several types of accessory dwelling units.

• Attached ADU: Built within a portion of the main house, such as a basement, attached garage or attic.
• Detached ADU: Located outside the main house, these units are also referred to as DADUs, backyard tiny homes and granny flats.
• Conversion ADU: Built using an existing space, such as a detached garage or an old guest house.
• Prefab ADU: Also known as manufactured or modular ADUs, these units are driven to your lot and placed in the backyard using a crane. Detached ADUs often fall into this category.
  Stick-built ADU: Built on location using traditional framing methods, stick-built units are usually made of wood cut on-site and assembled on the foundation.

The cost of an ADU varies based on the size, the type and where you live, though costs can range from $50,000 to over $400,000.

In addition to construction and labor, homeowners have to pay for permitting, design and inspections.

Companies like Abodu and Villa Homes provide prefab ADUS and will handle the entire process, so you don't have to find an architect, contractor or subcontractors.

If you don't have cash on hand to build an ADU, there are several ways to finance construction.

Home equity loan

A home equity loan is a second mortgage that uses the value of your home as collateral.

Interest rates are lower than with a personal loan and you can often borrow a larger sum and have up to 30 years to repay the principal and interest.

Rocket Mortgage is a top home equity lender that approves up to $30,000 for borrowers with as little as 10% equity home equity.

Home equity line of credit

Like a home equity loan, a home equity line of credit (HELOC) uses your home as collateral — but instead of a lump sum loan, you have a revolving line of credit with a 10-year draw period. That can be helpful with projects that end up costing more than you anticipated, such as building an ADU.

PNC Bank offers HELOCs with a maximum draw of up to $1 million, while TD Bank offers draws as low as $10,000 or as big as $6 million.

Home equity sharing

With a home equity sharing agreement, an investor buys a stake in your home and its future value by giving you a lump sum payment. After a predetermined term (or whenever you sell the home), you'll owe the investor the full amount you borrowed, plus a risk adjustment fee — an additional percentage of the home's new value.

Because it requires a significant payment all at once — and the risk adjustment fee can vary greatly — home equity sharing can be a risky strategy. But because eligibility requirements are more lax, it might be the right option if you have bad credit or a bankruptcy in your past.

You only need a credit score of 500 to score a home equity agreement with HomeTap or Point.

Cash-out refinance

If you're concerned about managing two home loans, a cash-out refinance is a simpler option. It replaces your existing mortgage with a larger one. The loan pays off your existing mortgage and the remaining funds are given to you in cash. Some lenders allow you to refinance up to 90% of your home's value.

You can close on your cash-out refinance from your house with LoanDepot and can get your new loan quickly with Rocket Mortgage, which has an average refinance close timeline of 21 days, much less than the average time to close.

Personal loan

Depending on the size of your project, you might be able to just take out a personal loan. Most lenders don't offer personal loans above $100,000, however, which may not be enough for your ADU. And interest rates will be higher than with a HELOC or home equity loan.

But because it's an unsecured loan, you won't risk foreclosure if you're unable to make payment.

Government loans and grants

State and local governments and nonprofits offer forgivable loans and grants to help subsidize the cost of building an ADU.

California: Rents in California average $2,500 a month, according to Redfin, and government programs in the Golden State incentivize ADU construction if they're used as affordable rental housing. The CalHFA Grant Program enables homeowners who make less than 80% of the area median income to apply for up to $40,000 to put toward ADU pre-building costs.

Colorado: The West Denver Single Family Plus ADU Pilot Program works with Denver homeowners at all income levels to make ADUs more affordable. Homeowners must choose from one of seven prefab floor plans for a detached ADU.

Massachusetts: Eligible homeowners can receive both a grant and loan from the Boston Home Center to help with permitting, designing and building their ADU. They can also apply for additional financing with a partner lender. 

New York: The Plus One ADU Program provides low- and middle-income single-family homeowners with forgivable loans of up to $175,000 to build or improve an ADU on their property.

Vermont: The Vermont Housing Improvement Program offers grants of up to $50,000 to qualified homeowners willing to rent out their future ADU at fair market rates for at least five years. In Montpelier, homeowners can get 0% interest loans and grants of up to $20,000 to complete their ADUs.

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