How a Reverse Mortgage Can Fund ADU Construction

March 1, 2023

By Nikkael Home Loans

Want to earn extra income while significantly increasing the value of your property? The answer may be building an Accessory Dwelling Unit (ADU).

In 2021, California passed the Housing Opportunity and More Efficiency Act (HOME Act). The HOME Act allows owners of homes in California to build an ADU on their property, even if local laws or applicable Codes, Covenants, and Restrictions (CC&Rs) prohibit such ADUs.

And, if you are at least 62 years old and have sufficient equity in your property, you will likely be able to finance the costs to build an ADU using a Reverse Mortgage, even if you currently have any type of mortgage on your home.

Here’s How It Would Look

Let’s look at an example where you would have $3,250 more per month of available cash. We’ll base it on these assumptions:

  • Current home value of $1 million.
  • Current mortgage balance of $200,000.
  • The cost to build and furnish the ADU is $150,000, assuming that the ADU will be 750 square feet and the cost to build and furnish is $200 per square foot.
  • The homeowner’s age is 68.

What You’d Get With a Reverse Mortgage

With the above assumptions (and based on current pricing), here’s how you would benefit from a reverse mortgage and receive money to build an ADU.

Your Existing Mortgage Would Be Paid Off

The first step would be to pay off your mortgage in full.

You Would Receive an Initial Line of Credit (LOC) of $39,600

This line of credit would be more than enough to get you started on the process of getting your ADU built (e.g., hiring an architect and contractor who will help generate the required plans to get all required building permits and all required approvals, if any, from other entities, like a Homeowners Association (HOA)).

With the LOC, you simply ask the lender/servicer of your new reverse mortgage for cash (up to $39,600 during the first year of your new HECM reverse mortgage) whenever you need it. The amount of the cash request will be sent to you, no questions asked, typically within a couple of days. And, with the Federal Government’s FHA-Insured Home Equity Conversion Mortgage (HECM) reverse mortgage, such LOC is guaranteed by the full faith and credit of the United States.

You Would Get an Additional $127,025.45 Added to Your LOC in a Year

This additional bump in your line of credit would happen on the one-year anniversary of your new reverse mortgage closing, giving you a total of $166,625.45 (i.e., the initial LOC of $39,600, plus the addition of $127,025.45 to your LOC a year later).

Since you only need $150,000 to build and furnish the ADU in this example, you would have at least $16,625.45 available in your LOC after building your ADU (i.e., the total LOC of $166,625.45, minus the $150,000 cost to build and furnish your ADU).

You also get the added benefit of having the unused portion of your LOC growing at the same rate on your HECM reverse mortgage. For example, in this illustration:

  • Your initial loan balance on your new HECM reverse mortgage would be $229,374.55, which is:
    • The payoff of your existing mortgage balance of $200,000, plus
    • The initial FHA mortgage insurance premium of $20,000 (which is 2% of the home value as determined by an appraisal of your home), plus
    • Estimated closing costs of $9,374.55, which would include things like the loan origination fee, title insurance premium, escrow fee, appraisal fee, recording fees, etc.

Interest Rate

The initial interest rate for your HECM reverse mortgage would be 7.37%, with a lifetime cap of 12.37%.

Please note that the interest rate is determined by adding the assumed margin of 2.500% (which would remain fixed for the life of your loan) to the index, which would adjust monthly and is the 1-Year Treasury Bill CMT. The CMT is an acronym for Constant Maturity Treasury. It is an index published daily by the Federal Reserve, but it may also be found on the Federal Reserve website.

Mortgage Insurance

The FHA Annual Mortgage Insurance Premium (Annual MIP) would be 0.50%, so the loan balance on your new HECM reverse mortgage would grow at 7.87% (i.e., the initial interest rate of 7.37%, plus the 0.50% Annual MIP).

For example, if you were to draw $5,000 on your initial LOC during the first month of your new HECM reverse mortgage, the loan balance at the end of the first month would be $235,911.66, calculated as follows:

  • $234,374.55 (i.e., the initial loan balance of $229,374.55 at the closing of the loan, plus the $5,000 draw from your initial LOC), plus
  • $1,537.11, which is the interest accrued during the first month and is calculated as follows:
    • The new loan balance of $234,374.55, times
    • The initial rate at which your loan balance grows (i.e., 7.87%), divided by
    • Twelve (12) months, since interest accrues monthly.

No More Mortgage Payments

You would have the option of NEVER having to make another mortgage payment for the rest of your life, so long as you:

  • Maintain your home,
  • Pay your property taxes and homeowners insurance premiums timely, and
  • Remain in your home as your principal residence.

Renting Out Your ADU

So, let’s assume you could rent out your ADU at $1,750 per month. At that point, you would have the option of:

  • Paying the full $1,750 per month towards your new HECM reverse mortgage. In this example, your loan balance would decrease by $212.89 (i.e., the $1,750 monthly rental on the ADU minus the monthly accrued interest of $1,537.11, assuming that the interest rate remains 7.87%), or
  • Using the $1,750 monthly as additional income while never making a mortgage payment. So, if your current mortgage payment were $1,500 per month, you would have $3,250 per month of additional income (i.e., the ADU monthly rental payment of $1,750, plus the elimination of the $1,500 payment on your current mortgage).

Call one of the Attorney Mortgage Loan Originators at Nikkael Home Loans today to help you analyze your situation and secure the best reverse mortgage!

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