How I Used a Cash-Out Refi to Finance a Granny Flat

Know when and how much to borrow for your granny flat by creating a clear plan first.

A cash-out refinance is one way to get the cash you need to convert an existing space into a separate living unit, or to build a new unit on the same property. The main requirement is that you have sufficient equity in the home to borrow against.

My husband and I want to create passive income streams in retirement, so we decided to build a new apartment (granny flat) above the garage. We used a cash-out refinance, which is where you replace your current mortgage with a new one of a higher amount. The first mortgage is paid off, and the difference is delivered to you in cash.

The process to finance our granny flat started long before the loan application. Here are the steps we took.

How much does it cost to build a granny flat?

As with most major home improvement projects, cost can be a major obstacle. Also, it's difficult to nail down the price at the onset. Many details can change or are as yet unknown.

To give you an idea, our 650-square-foot granny flat cost about $150,000. That comes out to $231 per square foot. In some cases, you could create a new second unit for half that. Even less if you convert an existing space.

Step 1: Build equity

The amount of money you can get from a lender via a cash-out refinance depends largely on two things: the amount of equity you have in the home and the loan-to-value (LTV) ratio. The LTV is the loan amount compared to the appraised value.

Some lenders allow more, but our lender limited the LTV to 60%. That was ample for us as we didn't want to drain too much equity. The two ways to build equity are to pay down your loan balance or wait for the property value to rise.

Step 2: Make a plan

Your plan is the foundation of your project. It should include all the work you want to do, and allow you to build a budget as the costs become clearer. The more specific your plan, the easier it will be to bring (and keep) costs down.

To develop a set of plans, we needed to get input from a surveyor, a structural engineer, and a draftsperson. All in, it cost about $5,600.

Step 3: Get the permits

The permit review process can be very intimidating. When you get to the permit office, you might wait a long time to be called, only to find you need to make corrections you don't fully understand. Permit fees vary from one city to the next. Ours totaled $4,200.

Most city employees are committed to helping homeowners succeed and will walk you through the process. If you do your homework ahead of time, show up prepared, and ask questions, you are likely to be met with helpful responses.

You could also pay an engineering firm or consultant to usher plans through on your behalf.

Step 4: Talk to contractors

Once you have a permitted set of plans, it's a great time to get bids from contractors. You can start researching contractors earlier in the process, but now's the time to pin them down.

The choices you make will drive a large portion of the final cost. For example, prices for items like flooring, tiles, plumbing fixtures, and cabinetry can vary wildly. If your plans are not detailed enough, contractors will make certain assumptions when they bid. If the bids are higher than you expected, ask if you can adjust your choices to reduce the cost. Be sure to get detailed information about what's included in every bid.

You can hire each professional separately and manage the work and the timeline yourself. Or you can hire a general contractor and let that person choose and manage all the subcontractors. The second option is much more convenient, but you'll pay more.

Step 5: Choose a lender and a loan

Once we knew how much it would cost, we were ready to shop for a loan. Many lenders offer cash-out refinance loans, but the terms vary, so shop around for the best refinance deal. You'll likely need to meet these basic requirements:

• 43% to 50% debt-to-income ratio
• 60% to 85% LTV limit
• Minimum FICO® Score of 620-680

Most borrowers apply for qualified mortgages (QM), which typically limit DTI to 43%, and allow a higher LTV. The borrower must prove his or her ability to repay using pay stubs, tax returns, and W-2 or 1099 forms.

My husband and I are both self-employed, so we opted for a non-QM loan. Our lender's DTI limit was 50%, and the LTV limit was 60%. We used our profit and loss statements to qualify instead of tax returns and pay stubs. The payment on our loan will be covered by the rent that we receive from the new unit.

Step 6: Manage your money

We reviewed our expenses every week to make sure we kept to our budget. It's easy for your spending to get out of hand on a big project, so you need to keep track.

Save money when you can. As a homeowner, you're legally allowed to do much of the work yourself. Some items, however, must be completed by a licensed contractor. You'll find out which ones during the permitting process.

Learn and have fun

Borrowing and spending $150,000 was both stressful and fun. We made plenty of mistakes. Give yourself permission to be imperfect. By the time you reach the end of the project, there will probably be many things you'll wish you'd known at the beginning. If I ever get the chance to do another six-figure remodel, this experience will certainly give me a huge head start.