California Borrowers Can Use ADU Rental Income for FHA Loans

FHA loans are a popular option for some home buyers in California, especially those with credit issues in the past. Now, a recent policy change from the Department of Housing and Urban Development could make it easier for some borrowers to qualify for FHA loans.

Specifically, this change will allow people to use rental income from accessory dwelling units (ADUs) to help qualify for an FHA loan in California. Some borrowers will be able to use up to 75% of their ADU-generated rental income for FHA mortgage underwriting and approval.

ADU Income Now Counts Toward FHA Loans

The U.S. Department of Housing and Urban Development (HUD) recently announced a new policy designed to broaden access to mortgage financing for homes with Accessory Dwelling Units (ADUs). This change supports the Biden-Harris Administration’s goals for increasing housing supply and promoting homeownership.

Under this new policy, mortgage lenders can now consider income generated from ADUs when underwriting and approving FHA loans. An ADU is a small housing unit situated within, attached to, or on the same property as the primary residence.

This is a significant change for homeowners in California who (A) have one or more accessory dwelling units on their property and (B) want to use an FHA loan to buy another property.

Going forward, the rental income from ADUs can be factored into a borrower’s qualifying income. This could help more borrowers in California qualify for FHA financing, including the popular 203(k) rehab loan program.

HUD, which oversees the FHA loan program, expects this policy to benefit first-time home buyers, seniors, and inter-generational families, allowing them to leverage ADUs to enhance the wealth-building potential of homeownership.

According to Sarah Edelman, HUD’s Deputy Assistant Secretary for Single Family Housing:

“The new policies provide greater flexibility for the use of rental income from ADUs, which will help more borrowers qualify for FHA-insured financing on homes with ADUs. We’re pleased that we’ve had such widespread support from the housing industry — support that has helped us deliver this meaningful solution for the nation’s homebuyers.”

Up to 75% of Income in Some Cases

The new policy regarding ADU rental income being applied to FHA loans took effect upon its announcement, in October 2023. Going forward, many California homeowners with accessory dwelling units will be able to use a portion of that income to quality for an FHA loan.

75% of Estimated ADU Rental Income

Some borrowers will be able to count 75% of their rental income from an existing ADU when applying for an FHA-insured mortgage. This added flexibility aims to increase access to homes with ADUs for buyers with limited incomes, allowing them to benefit from the wealth-building potential.

50% of Estimated Rental Income for New ADUs

Some borrowers planning to add a new ADU to an existing structure will be able to count 50% of the estimated rental income, to qualify for an FHA 203(k) rehab loan. This enables more homeowners with limited incomes to create ADUs, supporting homeownership and expanding access to rental housing.

Specific Appraisal Requirements

Appraisers will be required to identify, analyze, and report on ADU characteristics and the estimated rent they can generate. According to HUD, their new appraisal requirements and guidelines will help these appraisers “more accurately determine the market value of a property with an ADU.”

Financing New Construction

Going forward, accessory dwelling units will be added to the types of improvements that can be financed under FHA’s mortgages for new construction. This allows new homes to be constructed with ADUs from the beginning, accelerating the production of new units alongside the rehabilitation of existing structures.

What Is an Accessory Dwelling Unit?

An accessory dwelling unit (ADU), also known as a granny flat, in-law unit, or backyard cottage, is a secondary housing unit located on the same property as a primary residence. ADUs can be attached to the main house or detached, and they can be above a garage, in a basement, or even a converted shed.

Across California, ADUs are becoming increasingly popular in residential real estate for a number of reasons. They can provide additional income for homeowners who rent them out, or they can be used to house family members or caregivers. ADUs can also be a good option for people who want to downsize from their main home or want to age in place.

How ADUs Help the California Housing Market

Accessory Dwelling Units can help ease California’s housing shortage in a number of ways:

• Increase the supply of housing: ADUs are a relatively quick and easy way to add new housing units to existing neighborhoods. They can be built in a variety of sizes and styles, and they can be used for a variety of purposes, including renting them out to tenants or housing family members.
• Make housing more affordable: ADUs are often more affordable than traditional single-family homes, both to build and to rent. This is because they are typically smaller and less complex than single-family homes. ADUs can also provide a source of income for homeowners, which can help them offset their own housing costs.
• Reduce traffic and congestion: ADUs can help reduce traffic and congestion by providing housing options closer to jobs and public transportation. This is because ADUs can be built in existing neighborhoods, which are often closer to these amenities than new development areas.
• Address the state’s aging population: California has a large (and growing) aging population. ADUs can provide housing options for seniors who want to stay in their homes and communities as they age.
• Support the state’s economy: ADUs can create jobs in the construction and housing industries. They can also generate revenue for local governments through property taxes and other fees.

Where to Learn More

We’ve provided this report as a service to California homeowners with ADUs who wish to use an FHA loan to purchase and/or rehab another property. If you’d like to learn more about this policy change, refer to HUD Mortgagee Letter 2023-17 (available online).

You can also contact our staff if you have questions about using an FHA loan to buy a home in California. Bridgepoint Funding serves borrowers all across the state and offers a variety of financing options, including FHA, VA and conventional home loans.