diff --git a/cmake/app/boilerplate.cmake b/cmake/app/boilerplate.cmake
index f69c628cc74..2ccc8c3515c 100644
--- a/cmake/app/boilerplate.cmake
+++ b/cmake/app/boilerplate.cmake
@@ -424,6 +424,17 @@ please check your installation. ARCH roots searched: \n\
 ${ARCH_ROOT}")
 endif()
 
+if(DEFINED APPLICATION_CONFIG_DIR)
+  string(CONFIGURE ${APPLICATION_CONFIG_DIR} APPLICATION_CONFIG_DIR)
+  if(NOT IS_ABSOLUTE ${APPLICATION_CONFIG_DIR})
+    get_filename_component(APPLICATION_CONFIG_DIR ${APPLICATION_CONFIG_DIR} ABSOLUTE)
+  endif()
+else()
+  # Application config dir is not set, so we default to the  application
+  # source directory as configuration directory.
+  set(APPLICATION_CONFIG_DIR ${APPLICATION_SOURCE_DIR})
+endif()
+
 if(DEFINED CONF_FILE)
   # This ensures that CACHE{CONF_FILE} will be set correctly to current scope
   # variable CONF_FILE. An already current scope variable will stay the same.
@@ -441,14 +452,9 @@ if(DEFINED CONF_FILE)
     # Need the file name to look for match.
     # Need path in order to check if it is absolute.
     get_filename_component(CONF_FILE_NAME ${CONF_FILE} NAME)
-    get_filename_component(CONF_FILE_DIR ${CONF_FILE} DIRECTORY)
     if(${CONF_FILE_NAME} MATCHES "prj_(.*).conf")
       set(CONF_FILE_BUILD_TYPE ${CMAKE_MATCH_1})
       set(CONF_FILE_INCLUDE_FRAGMENTS true)
-
-      if(NOT IS_ABSOLUTE ${CONF_FILE_DIR})
-        set(CONF_FILE_DIR ${APPLICATION_SOURCE_DIR}/${CONF_FILE_DIR})
-      endif()
     endif()
   endif()
 elseif(CACHED_CONF_FILE)
@@ -459,21 +465,19 @@ elseif(CACHED_CONF_FILE)
 elseif(DEFINED ENV{CONF_FILE})
   set(CONF_FILE $ENV{CONF_FILE})
 
-elseif(EXISTS   ${APPLICATION_SOURCE_DIR}/prj_${BOARD}.conf)
-  set(CONF_FILE ${APPLICATION_SOURCE_DIR}/prj_${BOARD}.conf)
+elseif(EXISTS   ${APPLICATION_CONFIG_DIR}/prj_${BOARD}.conf)
+  set(CONF_FILE ${APPLICATION_CONFIG_DIR}/prj_${BOARD}.conf)
 
-elseif(EXISTS   ${APPLICATION_SOURCE_DIR}/prj.conf)
-  set(CONF_FILE ${APPLICATION_SOURCE_DIR}/prj.conf)
+elseif(EXISTS   ${APPLICATION_CONFIG_DIR}/prj.conf)
+  set(CONF_FILE ${APPLICATION_CONFIG_DIR}/prj.conf)
   set(CONF_FILE_INCLUDE_FRAGMENTS true)
 endif()
 
 if(CONF_FILE_INCLUDE_FRAGMENTS)
-  if(NOT CONF_FILE_DIR)
-     set(CONF_FILE_DIR ${APPLICATION_SOURCE_DIR})
-  endif()
-  zephyr_file(CONF_FILES ${CONF_FILE_DIR}/boards KCONF CONF_FILE BUILD ${CONF_FILE_BUILD_TYPE})
+  zephyr_file(CONF_FILES ${APPLICATION_CONFIG_DIR}/boards KCONF CONF_FILE BUILD ${CONF_FILE_BUILD_TYPE})
 endif()
 
+set(APPLICATION_CONFIG_DIR ${APPLICATION_CONFIG_DIR} CACHE INTERNAL "The application configuration folder")
 set(CACHED_CONF_FILE ${CONF_FILE} CACHE STRING "If desired, you can build the application using\
 the configuration settings specified in an alternate .conf file using this parameter. \
 These settings will override the settings in the application’s .config file or its default .conf file.\
@@ -482,7 +486,7 @@ The CACHED_CONF_FILE is internal Zephyr variable used between CMake runs. \
 To change CONF_FILE, use the CONF_FILE variable.")
 unset(CONF_FILE CACHE)
 
-zephyr_file(CONF_FILES ${APPLICATION_SOURCE_DIR}/boards DTS APP_BOARD_DTS)
+zephyr_file(CONF_FILES ${APPLICATION_CONFIG_DIR}/boards DTS APP_BOARD_DTS)
 
 # The CONF_FILE variable is now set to its final value.
 zephyr_boilerplate_watch(CONF_FILE)
@@ -492,10 +496,10 @@ if(DTC_OVERLAY_FILE)
   # in the CMakeCache.txt.
 elseif(APP_BOARD_DTS)
   set(DTC_OVERLAY_FILE ${APP_BOARD_DTS})
-elseif(EXISTS          ${APPLICATION_SOURCE_DIR}/${BOARD}.overlay)
-  set(DTC_OVERLAY_FILE ${APPLICATION_SOURCE_DIR}/${BOARD}.overlay)
-elseif(EXISTS          ${APPLICATION_SOURCE_DIR}/app.overlay)
-  set(DTC_OVERLAY_FILE ${APPLICATION_SOURCE_DIR}/app.overlay)
+elseif(EXISTS          ${APPLICATION_CONFIG_DIR}/${BOARD}.overlay)
+  set(DTC_OVERLAY_FILE ${APPLICATION_CONFIG_DIR}/${BOARD}.overlay)
+elseif(EXISTS          ${APPLICATION_CONFIG_DIR}/app.overlay)
+  set(DTC_OVERLAY_FILE ${APPLICATION_CONFIG_DIR}/app.overlay)
 endif()
 
 set(DTC_OVERLAY_FILE ${DTC_OVERLAY_FILE} CACHE STRING "If desired, you can \
diff --git a/cmake/kconfig.cmake b/cmake/kconfig.cmake
index 1aac82f0dea..a3de2156f96 100644
--- a/cmake/kconfig.cmake
+++ b/cmake/kconfig.cmake
@@ -199,7 +199,7 @@ foreach(f ${merge_config_files})
   if(IS_ABSOLUTE ${f})
     set(path ${f})
   else()
-    set(path ${APPLICATION_SOURCE_DIR}/${f})
+    set(path ${APPLICATION_CONFIG_DIR}/${f})
   endif()
 
   list(APPEND merge_config_files_with_absolute_paths ${path})
diff --git a/doc/application/index.rst b/doc/application/index.rst
index bb59b8c18ac..a8ee20b3dab 100644
--- a/doc/application/index.rst
+++ b/doc/application/index.rst
@@ -587,6 +587,29 @@ documentation `runningcmake`_ .
 Application Configuration
 *************************
 
+.. _application-configuration-directory:
+
+Application Configuration Directory
+===================================
+
+Zephyr will use configuration files from the application's configuration
+directory except for files with an absolute path provided by the arguments
+described earlier, for example ``CONF_FILE``, ``OVERLAY_CONFIG``, and
+``DTC_OVERLAY_FILE``.
+
+The application configuration directory is defined by the
+``APPLICATION_CONFIG_DIR`` variable.
+
+``APPLICATION_CONFIG_DIR`` will be set by one of the sources below with the
+highest priority listed first.
+
+1. If ``APPLICATION_CONFIG_DIR`` is specified by the user with
+   ``-DAPPLICATION_CONFIG_DIR=<path>`` or in a CMake file before
+   ``find_package(Zephyr)`` then this folder is used a the application's
+   configuration directory.
+
+2. The application's source directory.
+
 .. _application-kconfig:
 
 Kconfig Configuration
diff --git a/doc/guides/build/kconfig/setting.rst b/doc/guides/build/kconfig/setting.rst
index 41ed19c0bd0..fa919f62566 100644
--- a/doc/guides/build/kconfig/setting.rst
+++ b/doc/guides/build/kconfig/setting.rst
@@ -154,18 +154,26 @@ The application configuration can come from the sources below. By default,
    :file:`boards/<BOARD>_<build>.conf` is used.
 
 3. Otherwise, :file:`prj_<BOARD>.conf` is used if it exists in the application
-   directory.
+   configuration directory.
 
 4. Otherwise, if :file:`boards/<BOARD>.conf` exists in the application
-   directory, the result of merging it with :file:`prj.conf` is used.
+   configuration directory, the result of merging it with :file:`prj.conf` is
+   used.
 
 5. Otherwise, if board revisions are used and
    :file:`boards/<BOARD>_<revision>.conf` exists in the application
-   directory, the result of merging it with :file:`prj.conf` and
+   configuration directory, the result of merging it with :file:`prj.conf` and
    :file:`boards/<BOARD>.conf` is used.
 
 6. Otherwise, :file:`prj.conf` is used if it exists in the application
-   directory
+   configuration directory
+
+All configuration files will be taken from the application's configuration
+directory except for files with an absolute path that are given with the
+``CONF_FILE`` argument.
+
+See :ref:`Application Configuration Directory <application-configuration-directory>`
+on how the application configuration directory is defined.
 
 If a symbol is assigned both in :file:`<BOARD>_defconfig` and in the
 application configuration, the value set in the application configuration takes
diff --git a/tests/cmake/config_dir/CMakeLists.txt b/tests/cmake/config_dir/CMakeLists.txt
new file mode 100644
index 00000000000..6078e3074d3
--- /dev/null
+++ b/tests/cmake/config_dir/CMakeLists.txt
@@ -0,0 +1,32 @@
+# SPDX-License-Identifier: Apache-2.0
+
+cmake_minimum_required(VERSION 3.20.0)
+
+if(DEFINED APPLICATION_CONFIG_DIR)
+  # Has been specified as relative on CMake invocation, convert to absolute
+  # and keep reference to see it's identical when Zephyr boilerplate returns.
+  get_filename_component(EXPECTED_APPLICATION_CONFIG_DIR ${APPLICATION_CONFIG_DIR} ABSOLUTE)
+else()
+  # We expect a board config setup
+  set(EXPECTED_APPLICATION_CONFIG_DIR ${CMAKE_CURRENT_SOURCE_DIR}/boards/${BOARD})
+endif()
+
+find_package(Zephyr REQUIRED HINTS $ENV{ZEPHYR_BASE})
+
+project(app_config_dir_test)
+
+if(CONFIG_FAIL_TEST)
+  message(FATAL_ERROR "Test failed, "
+    "actual CONFIG_FAIL_TEST=${CONFIG_FAIL_TEST}, "
+    "expected CONFIG_FAIL_TEST=n"
+  )
+endif()
+
+if(NOT "${APPLICATION_CONFIG_DIR}" STREQUAL "${EXPECTED_APPLICATION_CONFIG_DIR}")
+  message(FATAL_ERROR "Test failed, "
+    "actual APPLICATION_CONFIG_DIR=${APPLICATION_CONFIG_DIR}, "
+    "expected APPLICATION_CONFIG_DIR=${EXPECTED_APPLICATION_CONFIG_DIR}"
+  )
+endif()
+
+target_sources(app PRIVATE src/main.c)
diff --git a/tests/cmake/config_dir/Kconfig b/tests/cmake/config_dir/Kconfig
new file mode 100644
index 00000000000..184d3065257
--- /dev/null
+++ b/tests/cmake/config_dir/Kconfig
@@ -0,0 +1,8 @@
+# Copyright (c) 2021 Nordic Semiconductor ASA
+# SPDX-License-Identifier: Apache-2.0
+
+config FAIL_TEST
+	bool "Fail the test"
+	default y
+
+source "Kconfig.zephyr"
diff --git a/tests/cmake/config_dir/foo/prj.conf b/tests/cmake/config_dir/foo/prj.conf
new file mode 100644
index 00000000000..8ed5d32820d
--- /dev/null
+++ b/tests/cmake/config_dir/foo/prj.conf
@@ -0,0 +1,3 @@
+# If this config is loaded, then the test will pass and specifying a custom
+# configuration dir worked correctly.
+CONFIG_FAIL_TEST=n
diff --git a/tests/cmake/config_dir/src/main.c b/tests/cmake/config_dir/src/main.c
new file mode 100644
index 00000000000..22ed2438dcc
--- /dev/null
+++ b/tests/cmake/config_dir/src/main.c
@@ -0,0 +1,10 @@
+/*
+ * Copyright (c) 2021 Nordic Semiconductor ASA
+ *
+ * SPDX-License-Identifier: Apache-2.0
+ */
+
+void test_main(void)
+{
+	/* Intentionally left empty, we are testing CMake. */
+}
diff --git a/tests/cmake/config_dir/testcase.yaml b/tests/cmake/config_dir/testcase.yaml
new file mode 100644
index 00000000000..b553882293f
--- /dev/null
+++ b/tests/cmake/config_dir/testcase.yaml
@@ -0,0 +1,5 @@
+tests:
+  config_dir.user_defined:
+    platform_allow: native_posix
+    build_only: true
+    extra_args: APPLICATION_CONFIG_DIR:PATH=foo