When financing a San Diego ADU, the two most common paths are a cash-out refinance and a HELOC (home equity line of credit). The numbers look similar at first glance — you're tapping equity either way. But the structures are very different, and the right choice depends almost entirely on the rate on your existing first mortgage. For homeowners with sub-4% pre-2022 mortgages, HELOC almost always wins. For homeowners with current-market mortgages above 6%, cash-out usually does. Here's the math.
The headline difference
Cash-out refinance replaces your existing mortgage with a single new, larger loan. HELOC keeps your existing mortgage intact and adds a separate, second loan secured by your equity. The first decision drives everything else.
| Feature | Cash-out refinance | HELOC |
|---|---|---|
| Loan structure | Single new loan | Two loans (existing + HELOC) |
| Rate type (typical) | Fixed | Variable (prime + margin) |
| Disbursement | Lump sum at closing | Drawn as needed |
| Closing costs (% of loan) | 2-4% | 0-1% |
| 2026 typical rate | ~6.23% (Freddie Mac PMMS) | ~7.09-7.50% (national avg) |
| Max LTV | 80% (conventional) | 80-85% combined |
| Tax deductibility | Improvement-use only1 | Improvement-use only |
Scenario A: Existing mortgage at 3.25% (locked in 2021)
Setup: Home worth $1,100,000. Existing mortgage balance $500,000 at 3.25%. Want to fund a $250,000 ADU build.
Cash-out path
- Replace existing $500K loan with new $750K loan
- New rate: 6.23% (current 30-year fixed)
- New monthly P&I: $4,608
- Existing P&I being replaced: $2,176
- Net monthly increase: $2,432
- Closing costs (~3% of $750K): roughly $22,500
HELOC path
- Keep existing $500K loan at 3.25% ($2,176/mo)
- Open $250K HELOC at 7.50% (interest-only during 10-year draw)
- Interest-only HELOC payment: $1,562/mo
- Combined monthly cost: $2,176 + $1,562 = $3,738/mo
- Closing costs: typically $0-$2,500
The verdict
The HELOC saves $870/month — $10,435/year — and tens of thousands in closing costs. Why? Because the cash-out path forces you to re-price the entire $500K of existing debt at current rates, paying 6.23% on debt that's currently at 3.25%. The "extra" $250K isn't really extra — you're paying current-market rates on $750K when you only need $250K of new borrowing.
HELOC dominates for any homeowner whose existing mortgage rate is meaningfully below current-market rates. About 79% of California homeowners had sub-5% mortgage rates as of late 2024 — most of these homeowners should use HELOC for ADU financing.
Scenario B: Existing mortgage at 6.75% (originated 2024)
Same home value, same ADU project. Existing mortgage balance $500,000 at 6.75%.
Cash-out path
- Replace existing $500K loan with new $750K loan
- New rate: 6.23%
- New monthly P&I: $4,608
- Existing P&I being replaced: $3,243
- Net monthly increase: $1,365
- Bonus: existing balance is now at 6.23% instead of 6.75% — modest rate improvement
HELOC path
- Keep existing $500K loan at 6.75% ($3,243/mo)
- Open $250K HELOC at 7.50% ($1,562/mo interest-only)
- Combined monthly cost: $4,805/mo
The verdict
Cash-out saves $197/month — and the existing balance gets a small rate improvement (6.75% → 6.23%) as a bonus. The math reverses because there's no penalty for re-pricing the existing debt. Cash-out is the cleaner solution: single payment, fixed rate, predictable amortization.
The break-even rate
The general rule: HELOC wins when your existing rate is more than about 2 percentage points below current rate-and-term refinance rates. Cash-out wins when the gap is less than 1 point. The middle zone (1-2 points) requires running specific scenarios.
Why the spread? HELOC rates are typically 0.5-1.5% higher than first-mortgage rates.2 So even a HELOC at 7.50% on the new $250K can be cheaper than re-pricing the entire $750K from 3.25% to 6.23%. The arithmetic of avoiding the cash-out reset on existing debt almost always wins when the gap is wide.
HELOC rates are tied to prime rate, which tracks Fed policy. As of April 2026, prime sits at 6.75%, with HELOCs typically priced at prime + 0.5% to prime + 1.5%.3 If the Fed cuts in 2026-2027 (likely per current Fed signals), HELOC rates fall automatically. If the Fed surprises with hikes, your rate rises automatically. Plan around the variable nature: most lenders offer fixed-rate conversion options on outstanding HELOC balances, which lets you lock in rates if you become concerned about future increases.
Three scenarios that complicate the simple comparison
Scenario 1: Phased construction over 12-18 months
If your ADU build will draw funds gradually over a year, HELOC's interest-only-on-drawn-amount feature is dramatically cheaper than cash-out's "all $250K from day 1" structure. Cash-out forces you to pay interest on the full project budget from closing onward, even if you don't actually need most of the funds for 6-9 months.
HELOC math on phased draws: average outstanding balance during construction might only be $125K (half the total), meaning interest cost during construction is half what cash-out would charge. On a 14-month build, this saves $7,000-$10,000 in interest cost during construction alone.
Scenario 2: Ambiguous final cost
If your ADU project might cost $200K or might cost $300K (a real possibility — costs run over routinely), HELOC accommodates by simply not drawing funds you don't need. Cash-out locks you into a specific loan amount; if costs come in lower, you're paying interest on the difference for 30 years.
Scenario 3: ARV (after-renovation value) borrowing capacity
For homeowners with limited equity in current value but strong projected ARV, neither cash-out nor HELOC may provide enough capacity. A construction loan or Fannie Mae HomeStyle Renovation loan that underwrites to ARV can provide significantly more capacity. Full ADU financing options here.
Closing cost comparison
| Cost | Cash-out refinance | HELOC |
|---|---|---|
| Origination fee | 0.5-1% of loan | 0-0.5% |
| Appraisal | $600-$900 | $0-$700 (often AVM) |
| Title insurance (CA standard) | $1,500-$3,000 | $0-$500 |
| Recording fees | $200-$400 | $200-$400 |
| Other fees | $1,000-$2,000 | $0-$500 |
| Total typical range | $15,000-$30,000 | $0-$3,000 |
The closing cost differential alone often tilts borderline scenarios toward HELOC. Many lenders offer "no-closing-cost" HELOCs that cover all third-party fees — with the caveat that you keep the line open for a minimum period (usually 3 years) to avoid recoupment.
Tax deductibility (both paths follow the same rule)
For tax purposes, both cash-out and HELOC funds used for the ADU produce deductible interest under the IRS's "buy, build, or substantially improve" rule.1 A new ADU clearly qualifies as substantial improvement. Both paths are equivalent on tax treatment.
The catch: if some of your cash-out or HELOC proceeds go to non-improvement uses (debt consolidation, vacation, college tuition), the interest on those amounts isn't deductible. Track usage carefully if you'll be claiming the deduction. Full deduction details.
Decision framework
Three questions to determine which path fits:
- What's your current mortgage rate? If sub-4.5%, default to HELOC. If above 6%, default to cash-out.
- How will funds be drawn? Phased construction strongly favors HELOC. Single lump-sum payment to a contractor doing turn-key construction may favor cash-out.
- Are your project costs uncertain? Uncertainty favors HELOC. Fixed-bid contracts with high confidence favor cash-out.
The hybrid play
Some homeowners use both products strategically:
- Use HELOC during construction (low closing costs, draw as needed, interest-only)
- Once construction is complete and the ADU is producing rental income, refinance into a single cash-out loan that consolidates the first mortgage and HELOC balance
- The post-completion appraisal supports a higher property value (after-renovation value), allowing larger total loan capacity
This hybrid approach captures HELOC's construction-phase advantages while ending in cash-out's clean single-payment structure. It works best when interest rates are expected to fall after the construction period — locking in lower long-term rates than were available at project start.
Run cash-out vs HELOC scenarios for your situation.
Open the calculator →The honest read
The cash-out vs HELOC decision for ADU financing is mostly determined by your existing mortgage rate. If you locked in a sub-4% rate during 2020-2021, almost any cash-out scenario destroys value by re-pricing the whole loan; HELOC wins decisively. If your existing mortgage is already at current market rates, cash-out typically wins because it's cleaner and has fixed payments. Project structure (phased vs. lump-sum) and cost uncertainty matter, but they're secondary factors. Run both scenarios with real numbers before committing — the difference between the right choice and the wrong choice routinely runs $50,000-$150,000 over the life of an ADU project.
Rates and product terms vary by lender. Always verify current rates with multiple lenders. Educational content only — not legal, tax, or financial advice.
References
- Internal Revenue Service. (2024). Publication 936: Home mortgage interest deduction. Retrieved April 28, 2026, from https://www.irs.gov/publications/p936
- Bankrate. (2026, April 22). Current HELOC rates. Retrieved April 28, 2026, from https://www.bankrate.com/home-equity/heloc-rates/
- Freddie Mac. (2026, April 23). Primary mortgage market survey. Retrieved April 28, 2026, from https://www.freddiemac.com/pmms