Evidence or rational market valuations for home energy efficiency.

Investments in high-efficiency heating and air conditioning equipment, insulation, and other energy-efficient home features have historically been justified and promoted based on the investment payback to the homeowner. The payback period is the number of years needed to fully recover energy efficiency investments through reduced fuel costs. More recently, the U.S. Environmental Protection Agency initiated a marketing program called "ENERGY STAR Homes." This effort teaches that energy-efficient homes produce immediate positive cash flow for home buyers because the reduction in monthly fuel bills more than offsets the higher monthly mortgage payment needed to finance such investments. Some home buyers, however, still hesitate to invest in energy efficiency because they are uncertain that they would stay in their homes long enough to recover their investment through lower fuel bills and that they could recover an investment in energy efficiency when they sell their homes. Standard underwriting criteria for home mortgages can also increase the down payment requirements or mortgage insurance costs on these homes because energy efficiency investments raise the upfront price of a new home. Underwriting criteria may even prevent home buyers from qualifying for mortgages if the appraised value of the home does not fully reflect the value of energy efficiency investments. Home appraisals may not always reflect the cost of energy efficiency investments because research has never clearly demonstrated or quantified the relationship between energy efficiency and market value.

ENERGY-EFFICIENT HOMES AND STANDARD MORTGAGE UNDERWRITING CRITERIA

Even if energy-efficient home investments pay for themselves in energy savings, the cost of such investments can adversely affect the qualifying ratios for a home mortgage, including the front-end and back-end income ratios and the loan-to-value ratio. The front-end ratio (or housing-cost-to-income ratio) is monthly housing expenses (principal, interest, taxes, and insurance, or PITI) divided by gross monthly income. The back-end ratio (or total debt-to-income ratio) is total monthly obligations (including auto loans, for example) divided by gross monthly income. The loan-to-value ratio is the amount of the mortgage divided by the lower of the appraised value or price of the home.

Standard underwriting criteria for 30-year, fixed-rate mortgages include a 28% constraint for the front-end ratio and a 36% constraint for the back-end ratio. Neither of these standard criteria account for utility costs as part of monthly housing expenses (PITI) or total monthly obligations. Therefore, the cost of energy-efficient upgrades for a new home can increase the home buyer's monthly PITI or total obligations beyond the qualifying constraints, even when the savings in monthly fuel bills more than offsets the higher mortgage interest. This income ratio anomaly was substantially addressed when the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) responded to the energy crises of the 1970s by establishing energy-efficient mortgage (EEM) guidelines that allow for a "2% stretch" over normal income ratio criteria for energy-efficient home mortgages.(1) The 2% stretch means that the front-end ratio for an EEM is raised to 30%, and the constraint for the back-end ratio is raised to 38%. For a household earning $60,000 per year, the 2% stretch can accommodate up to about $100 per month for higher mortgage payments related to cost-effective energy efficiency upgrades.

The 2% stretch gives lenders more flexibility with income ratios for energy-efficient homes but does not allow any flexibility with the loan-to-value ratio. Home buyers generally must pay for mortgage insurance to qualify for a 30-year fixed-rate mortgage with a loan-to-value above 80%. They also pay higher rates for mortgage insurance if their loan-to-value exceeds 90%, and often cannot qualify for the mortgage if their loan-to-value exceeds 95%. For a typical $160,000 house, an 80% loan-to-value loan requires 20% down, or $32,000, resulting in a mortgage loan amount of $128,000. If $5,000 of energy-efficient upgrades are included in the purchase of the home, the price increases to $165,000, and a higher down payment is needed to maintain the same loan-to-value ratio. At best, if the appraised value for the home is $165,000, the home buyer must add $1,000 to the down payment to maintain an 80% loan-to-value. At worst, if the appraiser does not recognize any additional value for energy efficiency and estimates the appraised value at $160,000, then the home buyer must add the entire $5,000 to the down payment in order to maintain the 80% loan-to-value.

The Federal Housing Administration (FHA) offers an EEM that allows the incremental cost of energy-efficient, cost-effective upgrades to …