Since the late 1970s, states have tried to integrate energy efficiency considerations into the daily business practices of the housing finance, sales, and construction industries. Now, with cooperation from the housing and energy efficiency industries, both the federal government and conventional lenders have launched initiatives to overcome some of the market barriers.

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.

Who's Who and What's What in the EM Marketplace

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
and Primary Lenders

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.

Loan Originators and Real Estate

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.

Loan Underwriters and Appraisers

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.

Initial Freddie Mac and Fannie Mae Guidelines

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.

The Appraiser's Role

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.

How Do You Score a House? Finding a way to represent the energy efficiency of a house as a numerical or star-based "score" has probably been the most troublesome aspect of starting a home energy rating system. Since HERS are intended to compare houses to each other, a rating system must estimate energy use that is not related to the occupants' lifestyle. Yet, in order for the rating to be useful for banks lending money, it should give a reasonable representation of the energy dollars that will be saved by the occupants of a more efficient house. Most systems use standard occupancy patterns (such as thermostat settings, appliance run-times, and lighting hours) and calculate the heat transfer through surfaces using typical climate data for the region. They may then try to calibrate the results with average energy bills in the state by adding correction factors. The purpose is not, however, to estimate a given household's energy usage--that can be seen from the utility bills--but to give the house itself a "miles per gallon" rating that will not change from owner to owner. To do this, rating systems distinguish between "real property" that will stay with the house when occupants leave, and personal property that may not if the current occupants move out. But should a HERS consider a compact fluorescent screwed into a light fixture to be part of the house or is it occupant-dependent? What about a window air conditioner, or a refrigerator? Some of the appliances that HERS typically exclude from their rating scores can be very large energy users. Swimming pool heaters, for instance can have an enormous impact on a resident's energy bills and ability to pay back a loan. The rated house must be compared to some sort of reference, but what should that be--the most efficient house possible? the least efficient? a house that meets a given new-building code? the "average" house in the area or state? Most systems use a house of the same size and shape as the one being rated, so that the rating really yields energy-efficiency per square foot --like giving cars a miles-per-gallon rating per ton. A small house that would use less energy to heat and cool may rate lower than an energy-hogging large house with more-efficient equipment. The National HERS Council Sets Guidelines To increase the credibility of HERS with national lenders, the U.S. Department of Energy (DOE) contracted with the national Home Energy Rating Systems Council (HERS Council) to develop voluntary uniform guidelines for rating systems. The HERS Council includes representatives from the rating providers, utilities, electric and gas industry groups, builders, primary and secondary lenders, appraisers, efficiency-product manufacturers, realtors, and consumers. The guidelines include a list of minimum rated features, on-site inspection procedures for accurate identification of types and efficiency of equipment and the house structure, standard default values for items that cannot be verified visually by the rater, assumptions for operating conditions, requirements for using climate data, and quality assurance prescriptions. The HERS Council worked with the National Renewable Energy Laboratory (NREL) to design a computer software test (called the Bestest) to assure that accredited HERS, given the same house, will estimate similar heating and cooling loads. The proposed HERS Council guidelines also include a designated rating method that requires accredited HERS to compare the site energy of the rated house to that of an "efficient" reference house (with the same size, shape, and fuel type) developed by the HERS council. U-values for the building structure of the reference house are based on the 1993 Council of American Building Officials' Model Energy Code (MEC) with 1994 amendments, and HVAC and water heating equipment meets efficiency standards in the National Appliance Energy Conservation Act of 1992. The reference house is the "benchmark" for a four-star rating. Using this system, electric houses can only be compared to other electric houses, and gas to gas. This proposed method contrasts to some existing rating systems. Many HERS use a state energy code as the four-star efficient reference and argue that the MEC is likely to become outmoded in the years ahead, and although the HERS Council reference is not intended to be used for code compliance, it could become confusing. Another approach, used by the California Home Energy Efficiency Rating System (CHEERS), is to compare rated houses to a "no-conservation" reference house. The CHEERS model uses source energy, so the energy required to produce electricity at the power plant and transmit it to a house is considered as energy used by an appliance. This allows CHEERS to compare energy use of appliances that use different fuel sources--in fact, electric resistance space and water heaters are the minimum efficiency equipment used to model the reference house, regardless of the fuel source of the equipment in the rated house. Many argue, however, that it is difficult to determine a source-energy multiplier when electricity is produced from a varied range of sources, while others point out that it is estimated all the time by energy analysts and can be updated as the fuel mix changes. Stars and Scores The HERS Council has also developed a guideline for assigning stars to the rating scores to provide a simpler, more visual representation for lenders, realtors, and buyers to make quick comparisons. Whereas the 0-100 scale is directly related to energy consumption (as a ratio of energy consumption of the rated to the reference house), most star systems are based on other factors as well. The proposed HERS Council guidelines (above), for instance, provide incentives for new-home builders to build to higher efficiency by requiring less energy savings to gain a star at the upper reaches of the scale. While it would take an improvement of 40 points to improve a house from one star to two stars, the difference between a three-star and a five-star house can be as little as seven points. Many existing HERS use a five-star system with "plus" delineations to provide more distinction between houses in the same general efficiency range, while others, like CHEERS, currently use only a 0-100 score system. -- Jeanne Byrne

How An Energy Mortgage Works
The first example at right compares standard loan accounting to using a 2% stretch of the qualifying ratio for a buyer seeking an energy-efficient mortgage on the same house. The second compares the standard loan to two methods of adjusting a mortgage to include energy improvements: using a 2% stretch of the qualifying ratio, and adding estimated monthly energy savings to the monthly principal, interest, taxes, and insurance (PITI) calculation. The method of subtracting energy savings from PITI also has an impact on the debt-to-income qualifying ratio (equivalent to 29.1% of the unadjusted PITI of $875, in this example). In some cases, this impact may result in more benefit to the buyer than the 2% stretch. These examples are from Colorado's Fannie Mae/Freddie Mac pilot program, which will be extended nationwide if it is successful. An EEM or EIM may be used to qualify the borrower if the home meets the threshold energy rating of 3-plus stars (score of 70) for a home completed prior to January 1, 1995 and 4 stars (score of 80) for a home completed on or after that date. A borrower can qualify for an EIM without meeting the threshold energy rating if the energy improvements will increase the energy rating by at least ten points (but only by the method of adding the energy savings to the PITI calculation).

Energy Improvement Loans

In the early days, Energy-Efficient Mortgage (EEM) qualifying ratio "stretches" found a niche in the new home construction market as builders realized they could qualify more buyers for their already energy-efficient (as often required by state and local building codes) homes. Energy Improvements Mortgages (EIMs), however, were less successful, largely due to the problem of appraisal value.

As originally developed by Freddie Mac and Fannie Mae, energy improvements of up to 5% of the value of a home loan were allowed to be added into a borrower's loan if the improvements could be justified in the appraiser's market value "comparable sales" analysis. If appraisers did not have adequate market data, they used a "present value" calculation of the projected energy savings from the retrofit.

Two major difficulties with this initial approach made it almost impossible for buyers to add energy improvements into their loans. First, since there was no way to compare the relative benefits of one home's energy package with another, appraisers could not evaluate whether a buyer's proposed energy improvements would have the same or similar resale value. Appraisers, asked to evaluate the benefits of such improvements, generally gave them little or no value. Thus, a home buyer, for instance, wanting to add $3,000 worth of improvements and pay for them over the life of a mortgage, might have to pay this amount "out-of-pocket" once the costs of the improvements were evaluated by the appraiser.

Second, while appraisers were allowed to calculate and add the present value of the savings to the mortgage, the market generally did not recognize the extra costs to appraisers in time and money to do this work. Even appraisers who wished to help a prospective buyer by doing the analysis found it difficult to recover their costs.

These barriers resulted in EIMs being used only rarely, although the states of Alaska and Vermont had innovative programs that fully integrated EIMs into their state Housing Finance Agency (HFA) lending programs. These HFAs built requirements for energy ratings into their existing lending programs in order to spur demand for ratings. Equally important, they created an awareness within the appraisal community of the need to use the energy rating data in their "comparable sales" analysis. Research in Alaska has shown that voluntary consumer investment in energy efficiency improvements has outpaced the cost of establishing and maintaining Alaska's program by an eight-to-one margin because homeowners (provided with clear information about their home's energy-efficiency status and potential for improvement) have proved willing to invest in energy savings and comfort.

The Veterans Administration's national EIM program allows energy improvements of up to $6,000 to be added to the mortgage loan without requiring an appraisal of the energy features. The VA program was used as the model for the Energy Policy Act of 1992 (EPACT) and the Housing Authorization Bill, which required the Federal Housing Administration to develop an EEM/EIM program using somewhat similar features (see "HUD's Energy-Efficient Mortgage Pilot," HE Nov/Dec '93, p.14).

Fixing the System

There is a renewed focus on EIMs, so that home buyers can add the cost of energy improvements to their home loans at the time of purchase and pay for the improvements monthly over the life of the mortgage.

The HUD/FHA program, like the VA program, simply allows buyers to add energy improvements to their mortgages without an appraisal. The buyer needs an energy evaluation showing the present value of the projected energy savings over the life of the measures, and this amount is then added to the market value of the loan. The VA's program differs slightly in that it requires a home buyer to show only that the increase in the monthly mortgage be equal to or lower than the projected monthly energy savings, that is, the energy improvements must generate a "positive cash flow."

These programs make it easier for home buyers to add energy-improvement costs to the loan. A home energy rating is required, but "comparable sales" market data are irrelevant to the loan process.

Some advocates of the EIM method used in the HUD and VA programs, believe that maintaining a distance between the EIM process and the traditional appraisal requirements of the mortgage industry is the only way to go. Others within the "conventional" secondary market, believe that the long-term viability of EIMs and EEMs depends on finding a way for energy efficiency, and these programs in particular, to be fully integrated into existing mortgage structures. Otherwise, they believe that energy programs will not be taken seriously by the housing industry.

Colorado's "Conventional" Market Approach

Recognizing a need to restructure their original approach to EIMs, Fannie Mae and Freddie Mac have taken this latter approach in a pilot program in Colorado. Both agencies plan to expand the Colorado model nationally. The program addresses the dual appraisal issues of the increased cost of completing the traditional present value and energy analysis and the lack of reliable comparable market data for appraisers.

Appraisers can use the "present value" analysis done by Energy Rated Homes of Colorado and the rating certificate as proof of the level of the home's energy efficiency. Using a new energy addendum (Form 70B/1004B to replace the traditional Freddie Mac Form 70A and Fannie Mae Form 1004A), appraisers simply add the "Energy Efficiency Value Increment" (the lower of the "present value" or cost of the improvements) to the market value to calculate a new "Total Estimated Value" for the home, a value that now includes the energy improvements.

Freddie Mac and Fannie Mae allow this process of adding the "Energy Efficiency Value Increment" to the appraised market value (for homes that can increase a minimum of ten points on the HERS scale) primarily as a way to "seed" the market for energy-efficient homes. By giving recognition that appraisal "comps" currently do not exist for energy-efficiency improvements, they hope to spur the use of EIMs, while building a reliable appraisal database. In the long run, this will show whether consumers are truly willing to pay more for homes identified as energy efficient than for similar, otherwise comparable, properties. As a means of "capturing" the energy rating information within traditional appraisal data sources, the Colorado program requires that the home energy rating be added into real estate Multi-Listing Service Data Banks, or similar sources available to appraisers. Within several years, appraisers may be able to use their traditional tools to analyze the impact of energy efficiency on home buying patterns.

DOE's Pilot

The U. S. Department of Energy (DOE) has formed a six-state pilot working group made up of the HUD pilot states of Alaska, Arkansas, California, Vermont, and Virginia, along with Colorado. The working group's mission is to create national consistency in areas ranging from use of a common energy rating scale to similarity in energy rating output forms used by lenders (see "How Do You Score a House?" p.30). Other goals include developing mechanisms for supporting new state program development and providing support to the pilot states to market HUD and Freddie Mac/Fannie Mae pilot EIM programs.

Energy Mortgages Set to Take Off

With the FmHA and VA programs, the five-state HUD/FHA pilot, and the Freddie Mac and Fannie Mae pilot up and running in Colorado (and likely to expand to other states soon), prospects for the success of energy mortgages have never seemed brighter. In addition, many local lenders are taking an active role to promote energy mortgages, often working with energy raters in their area. Fifteen years after the concept of linking energy efficiency with home loans was first tossed around the housing industry, energy mortgages may finally get the attention they deserve.

Jay A. Luboff manages Energy Rated Homes of Colorado for the Colorado Housing and Finance Authority. He also chairs the U.S. Department of Energy's six-state pilot energy mortgage working group.

This article is apart of a series of energy-efficient remodeling, which is being funded by the Environmental Protection Agency and the Department of Energy.

Selected Contacts: Jay Luboff Energy Rated Homes of Colorodo 1981 Blake St. Denver, CO 80202 (303)297-7395 Richard Faesy Energy Rated Homes of Vermont 127 Pine St. Burlington, VT 05401-4710 (802)965-3926 Barbara Collins Energy Rated Homes of Alaska 520 E. 34th Ave. Anchorage, AK 99503-4199 (907)563-6749 Carol Cales Energy Rated Homes of Arkansas 5401 JFK Blvd., Suite I North Little Rock, AR 72116 (501)771-2299 Michael Martin California Home Energy Efficiency Rating System 1700 Adams Ave., Suite 102 Costa Mesa, CA 92626 (714)540-0501 Christine Taylor Virginia Home Energy Rating Organization 804 Moorefield Park Dr., Suite 101 Richmond, VA 23235 (804) 560-9134 Chester Smith Energy Rated Homes of America POB 68734 Jackson, MS 39286 (601)366-0290 Cynthia Gardstein Home Energy Rating Systems Council 1511 K St., NW, Suite 600 Washington, DC 20005 (202)638-3700