Using Energy Mortgages (EMs)

Energy efficiency can be incorporated into the home loan process for both new and existing homes. An Energy Efficient Mortgage (EEM) allows the buyer of a highly-efficient house to qualify with a lower income, while an Energy Improvements Mortgage (EIM) allows the buyer to incorporate costs for energy-saving retrofits into a home loan.

When someone decides to buy or sell a home, they deal mostly with local lenders, builders, real estate agents, and appraisers. However, major financing for housing in the United States is secured through national "secondary mortgage market" purchasers, guarantors, and insurers, who provide confidence and financial structures for the local lenders. The secondary mortgage market, therefore, needs to consciously cooperate and collaborate with the effort to promote energy efficiency in the national housing industry. At the same time, local lenders, realtors, and appraisers must be willing to add this relatively new feature to the marketplace.

The secondary mortgage market consists of two components--the "governmental" market and the "conventional" market. Both provide local ("primary") lenders with access to funds or insurance guarantees. On the government side, the U.S. Department of Housing and Urban Development's Federal Housing Administration (HUD/ FHA), the Veterans Administration (VA), and the Farmers Home Administration (FmHA) all provide loan insurance or guarantees to primary lenders, giving them the confidence to "put mortgage money on the street." The conventional market is dominated by the Federal National Mortgage Association (FNMA), known as Fannie Mae, and the Federal Home Loan Mortgage Corporation (FHLMC), known as Freddie Mac. Fannie Mae and Freddie Mac offer to purchase all or part of the primary lender's loan portfolio and package the loans into "mortgage backed securities," which they then sell on the bond market.

For primary lenders to become involved in energy mortgage and rating programs, they must feel comfortable that Fannie Mae and Freddie Mac will buy, or the government (HUD/FHA, FmHA, or VA) will insure or guarantee, loans that have energy efficiency components built into them.

The loan officer or originator is the first contact with the buyer or the real estate agent. Since both the real estate agent and originator work on commission, they must feel confident that the process of adding energy considerations into the loan will in no way disturb normal financing and closing of the real estate deal.

Underwriters and appraisers work for the primary lender. The underwriter determines whether the buyer can meet secondary mortgage market criteria for the loan and the appraiser determines whether the property itself has the market resale value needed to ensure that the lender will recover the balance of the loan should the home go into default.

Freddie Mac and Fannie Mae, along with the national leadership of the mortgage industry, created the initial EM guidelines in response to the energy crises of the 1970s.

In 1979, Freddie Mac, soon followed by Fannie Mae, provided mortgage guidelines that allowed lenders to expand normal home qualifying ratio criteria for homes "identified as energy efficient." The concept was simple. Buyers of homes with reduced monthly energy costs could afford more expensive houses, since they had more disposable income than if they bought less efficient homes. This would also increase the number of potential homebuyers, since people could qualify with lower incomes.

In its initial guidelines, Freddie Mac allowed savings from reduced energy expenses to be added as disposable income by a home buyer to the traditional "P" (principle), "I" (interest), "T" (taxes), and "I" (insurance) mortgage calculation. Buyers could become eligible for expanded "debt-to-income" qualifying ratios of up to four percentage points, allowing a potential increase in purchasing power in certain cases of 7% to 10%. Fannie Mae's guidelines called for a direct 2% increase in qualifying ratio for homes identified as energy efficient.

Until recently, the Fannie Mae approach was the industry norm. However, newly developed national guidelines being tested in a pilot program in Colorado combine both approaches, allowing either a direct dollar-for-dollar energy savings to be added to the PITI, or the use of a standard 2% qualifying ratio stretch, depending on which benefits the buyer most (see "How an Energy Mortgage Works," p.31). The 2% qualifying ratio increase is "independent of other factors." In practice, this allows loan underwriters to begin qualifying buyers of highly efficient properties at higher debt-to-income ratios, leaving room for further expansion of ratios for other "compensatory factors" that may be taken into account.

Over the years, a major disincentive to the use of energy mortgage programs has been the lack of appraisal data to justify increased market values for highly efficient homes. Though Freddie Mac and Fannie Mae agreed in their initial guidelines to buy loans from local lenders, no procedure existed within the traditional appraisal practice to identify a home as "energy efficient."

Appraisers play a key role because they determine the "market value" of the property by comparing the value of the property the buyer wishes to purchase (called the "subject" property) to the value of recently sold nearby properties with similar features. This "comparable sales" analysis is used to determine if various features of the different properties (such as location, view, and proximity to schools) are contributing factors in any variation in price between otherwise similar homes.

Appraisers typically find information about homes that have recently sold in either the local Multi-Listing Service (which gathers and stores information about houses for sale and those recently sold) or specialized appraisal data centers with similar information. Without a widely accepted and used Home Energy Rating System, however, appraisers find it difficult to compare the energy features of one house to another. The inability to determine the true market value of energy efficiency has made it virtually impossible for buyers wishing to upgrade the efficiency of their homes at the time of purchase to add the cost of those upgrades to the mortgage.

This is a "chicken and egg" problem--without the data, appraisers cannot determine the value difference between the energy features of the "subject" property and the "comps" (comparable sales). Yet, without determining this value, homebuyers have difficulty adding money for energy improvements to the loan at the time of purchase, and recouping the cost of those improvements at the time of sale.

HERS Past and Present Henry Damus, Appraiser--The Unsung Hero of HERS and EMs In 1981, Henry Damus, a vice president for appraisal for a small savings and loan bank, approached the University of Washington's Western Resources Center and Institute (WRI) to help develop a method for appraisers to use in measuring the energy efficiency of homes. From Mr. Damus' interest grew the country's first "home energy rating" system. The first-ever industry meeting on energy mortgages and rating systems was held in late 1981 at the Federal Home Loan Bank in Seattle. The goal was to determine how to functionally add energy considerations into the mortgage process. Representatives from Freddie Mac, Fannie Mae, the Federal Home Loan Bank system, the Mortgage Bankers Association, the (then) American Society of Real Estate Appraisers, and the five major Multi-Listing Services gathered to find a way to deal with the "new" issue of energy efficiency in housing. Three basic concepts emerged and continue to guide the development of EMs and HERS programs. First, a home energy rating system was needed to adequately assess the energy-qualifying-ratio advantages offered by the secondary market. Second, any such rating system needed to be uniform and flexible, yet applicable in all parts of the country. Third, because of concern about future regulation, the system needed to be voluntary and created with local industry involvement and oversight. Out of this initial meeting grew the National Shelter Industry Energy Advisory Council, and then the non-profit home energy rating system now called Energy Rated Homes of America (ERHA). Using the model established by the national industry council, statewide Energy Rated Homes programs (typically seed-funded by state energy offices) were developed with housing industry oversight committees in several states. In fact, almost all HERS, including utility-created programs like the one in Fort Collins, Colorado, and the California Home Energy Efficiency Rating System (CHEERS) program (now a member of the Energy Rated Homes' Residential Energy Services Network), have been founded with voluntary industry cooperation. From Flood Plains to Energy Ratings The first HERS was based on the model of the appraisers' flood plains insurance rating system that had been originally developed in the 1950s and early '60s. This model's design, with minor variations, is used in almost all rating programs today. The flood plains rating system used a 0- to 100-point scale, broken into the five qualitative categories of poor, fair, good, very good, and excellent. Realtors involved in the program's development suggested using star-rating categories from one to five stars. Builders argued that the categories needed to show finer variation in the rating. Hence, plus (+) delineations between each star were added. In an energy rating, a 0-point home generally has very little or no possibility for holding energy (like a breezy garage with missing doors and windows), while a 100-point home uses no utility-supplied energy at all. These 100-point systems typically evaluate the efficiency of the home's envelope, its heating and cooling potential, its solar potential, its air leakage rate (using either a blower door analysis or visual evaluation), and the efficiencies of the home's space and water heating equipment. Several HERS have recently added heating duct loss analysis to the menu of energy features evaluated. In general, four-star homes are considered "energy efficient" by lenders. This has helped builders of relatively efficient new properties to take advantage of EEM programs, but it is more difficult for owners of older, existing homes to upgrade their homes to this standard. Recognizing that a considerable amount of energy can be saved in raising houses from, for example, a two-star rating to a three-plus rating, Freddie Mac and Fannie Mae developed new guidelines in Colorado for EEM qualifying ratio "stretches" to be made available to owners/buyers of existing homes at the three-plus star level. Several HERS programs, like the Energy Score program in Fort Collins, Colorado, and California's CHEERS, have opted, up until now, to use only the 100-point scale, forgoing the use of a qualitative star designation (see "How Do You Score a House?" p.30). Who's Got HERS? Fifteen HERS systems are currently operating and approximately twenty other states are developing or considering new HERS systems. While HERS programs vary in their marketing and in adaptation of rating tools to local climatic and housing market characteristics, the operation of the different programs is similar (see "Making HERS a Household Word," HE Sept/Oct '91, p. 30). Many share standardized formats or "rater checklists" used by energy raters to collect information and make recommendations for energy improvements on homes being rated, certification and training programs for energy raters, and centralized processing and distribution of rating data to the consumer. Some HERS programs also require blower door and duct testing on either all homes rated, or just those involving EMs. Most certified raters come from the housing and energy fields, with backgrounds ranging from home inspection, appraisal, and real estate sales to low income weatherization, energy auditing, insulation contracting, and related fields. In all cases, a centralized HERS program "operator" is responsible for quality control and monitoring of raters.