I recently did this at my house. I had a detached garage that didn't have any utilities - just an empty box. My house appraised for $300,000 at the end of 2017 and I owed $220,000 when I decided to break ground on the project.
The first thing I will say is that it ended up costing me almost double what I had estimated. I was aiming for $30,000 and it cost me over $60,000. I had $20,000 in savings and I planed to finance the kitchen/appliances with consumer credit cards.
I live in a nice area of Utah near the Cottonwood Canyons. My house is very small, but I'm right at the mouth of the canyon. I decided to add extra amenities to make it feel like more of a "resort quality" stay for short stay rentals. That certainly added to the cost, but a lot more than I bargained for! I did most of the labor myself and hired out an electrician and plumber, along with a handyman for big jobs. If I would have used a general contractor, I'm sure I would have paid close to $100,000.
As far as the financing goes, I made a lot of mistakes. I think the other answers are better advice from the banking perspective, but as a consumer, here's my opinion of the options:
1- Work on your credit score before you start.
I had a couple of items on my report that I didn't know about (mostly medical, but even the damn county library!). I didn't plan on borrowing a lot of money, so I didn't bother to sort it out. By the time I needed to, it was too late!
2- Shop around for a good mortgage.
I ended up going with a cash-out refinance out of necessity for survival! I kept trying to optimistic about completion date (was aiming to finish in November to take advantage of Christmas vacation renters). Anything that could go wrong, did go wrong! Regardless of late nights and long weekends, it's hard to coordinate everything with contractors and mistakes pop up all the time when you're new to construction. I didn't finish till January 1st.
3- Do your research on zoning/title status.
In my case, the "accessory dwelling" didn't add much value. As far as the zoning/tax record, none of the space counts as a kitchen, bathroom or bedroom! I'm sure they factored in the space for ascetic and selling appeal, but nothing towards my square footage which they use as the primary metric for comps they pull for appraisal. Luckily, the values in the area have kept climbing and had their highest YOY increase on record last year (13%!). My house appraised for $340,000. I estimate the general area value increase for the construction period of 18 months accounts for most of the $40k increase. (I did utility lines first, then paused for the winter)
4- Don't take signature loans/max credit cards!
It's SO hard to keep track of when payments are due when you're juggling hardware store cards, kitchen, tile warehouse, appliances, etc. I used all consumer credit card loans which was big mistake! You can only borrow above 80% of your home's appraisal value, but they add your consumer debt BEFORE they look at how much you can finance! The cash-out refi allowed me to pay off the loans, but not before I had late fees and finance charges.
For the "Is this a good idea part"? I think that depends... I'm a single parent with partial custody of 4 kids. It's been great to work on this project with my kids, so that weighs in emotionally. I've only had bookings so far, and it's been awesome! My first guests drove all the way from Quebec! They are great skiers and we had a wonderful time together!
For the dollars and cents part of the answer, everything is looking GREAT! I've had almost back-to-back bookings with AirBnB! I'm making nearly 3 times what I would make renting to a full-time tenant. There are a lot of extra costs, so probably closer to netting 2 times. I'm basing that off of a rent report I did in my area that suggested I could rent a 1 bed/ 1 bath condo for $1,000 / mo to get less than 5% vacancy. January I made nearly $2,000 but only had it rented for half the month (no one booked the first week, and I was still tying up lose ends). February is booked most of the month and already over $2,000. I have bookings into march.
I know that every area is different, but I mention my personal experience to highlight what I feel is a key point - with real estate it's all about location!
Checkout Rentler.com for a rent report! It was only $20! Worth every penny in helping me make the right choice! They also have great landlord tools if you decide to do a full time rental. Otherwise, AirBnB is working good so far!