low-cost financing: overview » introduction » energy efficient mortgages
Energy efficient mortgages (EEMs) allow homebuyers or owners who are refinancing or taking out a new purchase mortgage to add the cost of energy-efficiency improvements to the loan, often stretching debt-to-income ratios so that borrowers may qualify for a larger loan. Similar programs are available for new construction, allowing greater latitude for borrowers who demonstrate that their homes exceed model code requirements. (A variation on this theme is to provide a second mortgage to finance the improvements, while leaving the first mortgage intact.)

EEMs enable homeowners who lack the upfront funds for upgrades to borrow these additional costs, providing lower-cost financing payable over the term of the mortgage. Moreover, interest charged on EEMs qualifies for the mortgage interest deduction, enabling borrowers with sufficient income to receive an additional tax subsidy. Existing EEM instruments offer several mechanisms through which borrowers can qualify for financing that rolls in the cost of energy-efficient improvements, including:
  • Disregard cost of improvements for loan qualification purposes -- Under standard underwriting approaches, some moderate-income households may not qualify for a large enough home purchase or refinance loan to cover the costs of both the home and energy-efficiency improvements. Some EEMs disregard the added cost of improvements for loan qualification purposes, on the assumption that reduced utility costs will keep payments within families' budgets, making it easier for families to borrow the needed funds.
  • Adjust effective income by projected energy cost savings -- Rather than ignoring the cost of energy-efficient improvements in calculating the loan amount for loan qualification purposes, some EEM programs count anticipated energy cost savings towards the borrowers' income. This has the same effect of helping borrowers qualify for a larger loan that includes the cost of improvements.
  • Adjust home value to reflect expected efficiency improvements -- Energy-efficiency improvements are generally believed to enhance both the livability and the value of existing homes. Some EEMs account for projected increases in home value as a result of scheduled retrofits. If home values have not fallen too far, this feature could help homeowners who have become "underwater" on their mortgages to qualify for refinancing at a lower interest rate.
As indicated below, specific program details and requirements vary; however, in general, EEMs tend to share several characteristics. Typically, lenders set aside funds for the retrofits in an escrow account until any renovations or improvements have been completed. Most EEM programs also require pre- and post-rehab audits or assessments to measure initial efficiency levels and verify that improvements have been implemented in compliance with program requirements.
Solutions in Action
Currently operating as a pilot program in several states, the Energy Star Mortgage provides financing on favorable terms for homeowners wishing to make upgrades to enhance the energy efficiency of existing homes and homebuyers purchasing a new, Energy Star-qualified home. The Energy Star product wraps the cost of energy-efficiency investments into the loan; participating lenders further customize loan terms, including determining eligible expenses and choosing which incentives to offer in order to lower the borrower's financing costs.

Incentives may include discounted interest rates or loan fees, closing cost assistance (for new mortgages), and -- as in many other EEMs -- an extension of the allowable debt-to-income ratio, among others. Owners of existing homes must receive a pre-improvement audit through a Home Performance with Energy Star or Weatherization program in order to participate in the program, and targeted energy-efficiency improvements must be made under one of these two programs with the intent of achieving a 20 percent savings in energy costs. Click here to leave this site and learn more about Energy Star Mortgages.

Potential barriers to adoption of energy efficient mortgages

While energy efficient mortgages are not new, they have not yet broken into the broader market in a meaningful way. A recent evaluation of HUD's Green Building efforts by the Government Accountability Office revealed several barriers that may prevent more widespread use of the FHA products -- barriers that may apply to EEMs in general.
  • Added time -- For programs that require inspections by a rater before and/or after the improvements have been carried out, the additional time associated with these inspections has been identified as a potential obstacle to their widespread use. However, the recent slowdown in home sales could serve to mitigate this concern, with real estate agents more likely to accept delays that help to close sales in a slumping market.
  • Availability of qualified raters and contractors -- Lenders may require that audits be carried out by a Home Energy Rating System (HERS) accredited rater or that work be conducted by a certified contractor. (Learn more about supporting an energy-efficiency workforce.)
  • Lack of awareness -- A critique of HUD's energy efficient mortgage programs issued by the Federation of American Scientists identifies lender and borrower lack of awareness as "the most prominent obstacle to [the] market success" of EEMs. The Energy Star mortgage builds on familiarity with the Energy Star brand to promote the lending product; the resurgence in popularity of FHA-insured mortgages may also help to improve take-up of FHA EEMs.
Other concerns identified in the report, including the lack of performance data to demonstrate the benefits and financial payoff of energy improvements and the absence of universally agreed-upon standards and benchmarks to measure reductions in energy consumption, apply to a broad spectrum of energy-efficiency programs.

Location-Efficient Mortgages

As the name suggests, lenders that offer location-efficient mortgages (LEMs) factor in a home's location when determining the mortgage amount for which a household qualifies. The rationale behind a LEM, a product distinct from but conceptually related to an EEM, is that families living in walkable, urban communities or in close proximity to public transit rely less on personal vehicles, thereby reducing their transportation costs and increasing discretionary income. To account for these cost savings, LEMs' flexible underwriting standards allow families to qualify for larger loans than they might otherwise be granted. LEM lenders add the predicted savings, calculated using land-use and other data, to families' income and permit a more-generous qualifying ratio. In addition, location-efficient mortgages typically require a relatively low downpayment, making it easier for families to get into homes they may not otherwise be able to afford.

Allowing families to qualify for larger mortgages than they would ordinarily be eligible for may appear to be anachronistic, given the recent mortgage foreclosure crisis. However, recent analysis of foreclosure rates and location efficiency by the Center for Neighborhood Technology, as reported by the Natural Resources Defense Council, suggests a significant relationship between the two. Researchers looked at performance data for 40,000 mortgages in Chicago, Jacksonville, and San Francisco and found that the likelihood of mortgage foreclosure increased with neighborhood vehicle ownership levels (a proxy for location efficiency), controlling for household income, debt-to-income ratio at mortgage origination, and other key factors. By adjusting underwriting standards to account for neighborhood-level differences, lenders can offer products that reflect risk levels on a more fine-grained basis. Click here to access the report [PDF].

Location-efficient mortgages have not yet achieved significant market share; however, Fannie Mae currently offers LEMs up to $300,700 in four metropolitan areas -- click here to learn more.

While experience with LEMs is limited, in theory, one would expect that the widespread adoption of LEMs could have different effects in strong and weak markets. In weak markets, the higher borrowing power associated with LEMs could stimulate reinvestment in location-efficient areas, leading to revitalization and housing stock improvements. In strong housing environments, where the ability of the private market to develop new or renovated housing is often constrained by the regulatory environment and shortages of available land, it is possible that widespread use of LEMs will simply drive up the price of housing in location-efficient areas, without improving housing quality or overall affordability, by increasing all families' borrowing power equally.

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Make available energy efficient mortgages, which fold the cost of energy-saving upgrades into a new mortgage or refinance

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Offer special assessment programs that allow the costs of energy upgrades to be repaid through existing utility and municipal bills and largely offset through lower energy usage

Provide interest rate buy-down programs and other low cost loans to lower borrowing costs for energy-efficient improvements