TODAY’S STUDY: WHERE TO GET MONEY FOR HOME ENERGY EFFICIENCY
Scaling Energy Efficiency in the Heart of the Residential Market: Increasing Middle America’s Access to Capital for Energy Improvements
March 6, 2012 (Lawrence Berkeley National Laboratory)
Middle income American households – broadly defined here as the middle third of U.S. households by income – are struggling. Energy improvements have the potential to provide significant benefits to these households – by lowering bills, increasing the integrity of their homes, improving their health and comfort, and reducing their exposure to volatile, and rising, energy prices. Middle income households are also responsible for a third of U.S. residential energy use, suggesting that increasing the energy efficiency of their homes is important to deliver public benefits such as reducing power system costs, easing congestion on the grid, and avoiding emissions of greenhouse gases and other pollutants.
While middle income Americans have historically invested in improvements that maintain and increase the value of their homes, they have seen an important source of financing – the equity in their properties – evaporate at the same time that their access to other loan products has been restricted. A number of energy efficiency programs are deploying credit enhancements, novel underwriting criteria, and innovative financing tools to reduce risks for both financiers and borrowers in an effort to increase the availability of energy efficiency financing for middle income households. While many of these programs are income-targeted, the challenges, opportunities, and emerging models for providing access to capital may apply more broadly across income groups in the residential sector.
Challenges to Accessing Capital
The upfront cost of comprehensive home energy improvements is a barrier to investment. Many middle income households need financing to overcome this barrier – and capital access has plummeted in the wake of the recession.
Using Home Equity to Finance Home Improvements
Middle income homeowners have historically invested in improving their homes. In 2001, these households accounted for almost a third of all home improvements made in the U.S., and they financed more than 35 percent of their home improvement investments (Guerrero 2003).1 Compared to other households that financed improvements, middle income households were more inclined than other income groups to finance home improvements by borrowing against housing equity – two thirds of their financing was home-secured (see Figure 1).2
This is both good and bad news. The good news is that middle income households have historically invested in home improvements, and many (57 percent) have not needed financing to do so. The bad news is that the recession has eroded household savings – suggesting that more households will need financing to make improvements – at the same time that housing wealth, the primary asset against which middle income households borrow, has declined.
The Housing Collapse
A number of factors contributed to the enormous speculative housing bubble in the mid-2000s (Lansing 2011). By 2007, primary residences accounted for approximately one third of U.S. household assets. For middle income households, these primary residences represented an even greater share of their assets – almost 50 percent (Bucks 2009). 3 The financial crisis and ensuing recession have since caused a sharp decline in housing values across the United States. Single family home prices have declined by 32 percent from the housing market’s 2006 peak and carried household wealth down as well (see Figure 2) (S&P 2011).
This data masks more dramatic regional declines in housing values and the concentration of these price declines in low and middle value properties – those most likely to be owned by middle income Americans.4 For example, the Case-Shiller Home Price Index indicates that low tier properties in Atlanta have lost 55 percent of their value since peaking at the end of 2006 – almost double the average 23 percent property value decline in the city over that time (see Figure 2). 5,6 In other words, not only did middle income households have more of their wealth invested in their primary residences heading into the recession, but their primary residences have lost a greater percentage of their value than those of their wealthier peers.
While property values (across tiers) nationally have returned to 2003 levels,8 it would be incorrect to assume that the housing decline has only set middle income families back eight years. Many homeowners took advantage of rising property values by borrowing aggressively against their growing equity – leaving them with significant debt burdens that are, for some, larger than their home values. In fact, more than a quarter of all single family residential properties (13.3 million households) are now underwater or have near negative equity (<5% equity) (Corelogic 2011). This negative equity is concentrated regionally – the top five states have 38 percent of all negative equity properties.9 It is reasonable to assume that many of these underwater properties are owned by middle income Americans – these households took on significant debt to purchase and improve properties, are more vulnerable to financial stress during a recession, and lost more of their home’s value than their wealthier peers. These underwater households are more likely to behave like renters, under-investing in improving and maintaining their homes.
The news is not all bad though. While a majority of families across income groups have recently experienced declines in income and wealth – and middle income households have been hit harder than their wealthier peers – a large minority of the middle income population has maintained or increased their levels of wealth. From 2007 to 2009, most families (63 percent) experienced wealth declines – for those whose wealth declined, the median loss was substantial, 45 percent (Bricker 2011). However, more than a third of households (37 percent) have not experienced wealth declines or have seen only small changes in wealth. This makes it difficult to make universal conclusions about the state of middle income household finances. While many households are unquestionably suffering – and are likely unwilling or unable to make significant investments in energy efficiency without substantial financial incentives – a large minority of middle income households may be able to invest.
Household Savings & Employment
Many American households feel insecure about their economic futures. Uncertainty about future earnings is high – in 2007, 31.4 percent of all families (across income groups) reported that they did not have a good idea of what their income would be for the next year (Bucks 2009). This uncertainty may well be even higher today as the U.S. unemployment rate has almost doubled since mid-2007. In 2009, almost nine percent of middle income households were unemployed while another 5.5 percent were underemployed (workers that take part-time jobs due to lack of available of full-time jobs) (Sum and Khatiwada 2010).10
For those households who have a reasonable expectation of future earnings, the recession has decreased their expectations of annual income growth from around two to three percent before the recession to less than half a percent in its wake – the lowest level in more than 30 years (Dunne and Fee 2011). Lower future earnings expectations are a function of both the recession and longer term trends – over the last 30 years, wages have not kept up with worker productivity gains.11 Uncertainty and pessimism about future earnings are making households increasingly cautious with their finances as many households report higher levels of desired savings to buffer themselves from economic and other emergencies (Bricker 2011). These homeowners are likely to make fewer proactive home improvements, like energy upgrades, in favor of preserving limited savings and access to credit for unforeseen hardships.
Qualifying for Credit
For those middle income households motivated to pursue energy efficiency, access to low-cost capital is often a significant barrier to investment. Many of the largest energy efficiency loan programs have application decline rates in the 30 to 50 percent range. Household ability to obtain secured financing has declined as housing prices have eroded and lenders have tightened underwriting standards and credit limits (NAR 2011).12 Similar tightening trends are occurring in unsecured lending as personal creditworthiness has weakened and lenders have responded by increasing the minimum credit scores required to qualify for financing products and reducing the amount of overall credit available to each qualified borrower. Many households turn to high interest credit cards to finance expenditures as their options dwindle. These high-cost financing products are ill-suited to energy improvements – particularly those for which the motivation is to save money – as they worsen the payback period of these investments.
Since 2009, approximately 10,000 households have applied for financing through Pennsylvania’s Keystone Home Energy Loan Program (HELP)13. About 40 percent of these households earn 80 percent of AMI or less, suggesting that many middle income households are attracted to the program.14 However, the program’s early experience shows that middle income households are more difficult to serve – 57 percent of households earning ≤ 80 percent AMI do not meet the program’s underwriting standards compared to 31 percent for households earning >80 percent AMI (see Table 1).
In addition to this higher rejection rate, fewer lower income households move forward with financing than their wealthier peers (58 percent of approved households earning ≤ 80 percent AMI fund loans compared to 73 percent of higher income households) – supporting the idea that, for many reasons, even when financing is available, it is more difficult to motivate middle income households to invest. Still, this data shows some promise as these middle income households account for about a quarter of all Keystone HELP loan volume.
According to the Indianapolis Neighborhood Housing Partnership (INHP), the homeowners that they serve typically have little access to anything but credit card financing – often at annual rates from 15 to 25 percent, so INHP’s new EcoHouse Project’s mid-single digit fixed-interest rate loans16 are an attractive tool for enabling energy improvements among households who are otherwise unlikely to be able to access affordable financing. With relatively lenient underwriting standards including credit scores as low as 580,17 INHP is able to accommodate a wider range of applicants. Credit scores estimate an individual’s likelihood of repaying certain types of debt relative to one’s peers.
Credit scores are a key metric for most lenders in evaluating consumer creditworthiness. Because credit scores are relative measures, a large shift in bill payment trends, like that caused by the recession, has triggered an increased likelihood of loan default for each “band” or range of credit scores. In other words, a credit score of 720 today reflects a higher estimated risk of loan non-payment than a credit score of 720 in 2005. For example, in the case of VantageScore, the delinquency rate on a new loan issued to a person with a 720 score between 2008 and 2010 is expected to be twice as high as on a new loan issued between 2003 and 2005…
Although credit scores do not explicitly take income into account, middle income households are likely to have lower credit scores than their wealthier peers (see Figure 3). These lower scores may be in part due to creditworthiness and in part due to the way in which scores are calculated, notwithstanding issues about how middle income households manage their credit. For example, a key factor in calculating credit scores is one’s ratio of credit utilization to credit availability – many middle income households have less overall credit availability than their wealthier peers, often causing their credit utilization rate to be higher and their credit scores to be lower. This lower credit access may be a function of many things, including lower absolute levels of home equity and post-recession reductions in the maximum loan sizes lenders offer to customers. In other words, income implicitly impacts some credit scores – even in cases of identical loan repayment histories, middle income households may be assigned lower credit scores than their wealthier peers.
Most lenders use credit scores as just one of several metrics for evaluating consumer creditworthiness. Underwriting standards for loan products, including those for home improvements, frequently include both a minimum credit score and a maximum debt-to-income (DTI) ratio.22 A Federal Reserve Board study found that more than 20 percent of all households with home-secured debt had net DTI ratios higher than 40 percent, suggesting that as many as one in five households may not qualify for financing programs that include a maximum DTI underwriting requirement (Bucks 2009).23 These numbers are higher among middle income households – more than one in three middle income households (35 percent) had net DTIs exceeding 40 percent.
Program experiences to date suggest that maximum DTI underwriting requirements are significant barriers to capital access. For example, NYSERDA has declined more loan applications because household DTI ratios exceed the allowable limit than for any other reason. Forty-three percent of NSYERDA’s loan application declines (17 percent of loan applicants) have been caused by excessive DTI ratios while just 23 percent of declines were triggered by low household credit scores (See Figure 4). Major credit events like bankruptcy, foreclosure, repossession and outstanding collections account for more loan denials (33 percent) than low credit scores – these loan applicants will be very difficult to serve moving forward.
Opportunities for Increasing Access to Capital…Credit Enhancements…Alternative Underwriting Criteria…
Innovative Financing Tools
In addition to making standard loan products more accessible, a number of new financial products may be more effective at serving middle income households. Here, we highlight four of these financing tools: OBF loan products that are paid off when properties transfer, employer-offered financing that is deducted from paychecks, and property assessed clean energy (PACE).
On-Bill Financing (OBF)
On-bill financing is a tool through which a customer’s utility bill is used to collect loan payments for energy improvements. Utilities or third parties can provide the up-front capital for the energy upgrades and the loan can be structured as an unsecured consumer loan, a secured loan, or can be attached to the meter (as opposed to the individual).38 Some utilities have expressed reservations about performing lending functions in-house, suggesting that third party-funded on-bill models in which financial institutions have core lending responsibilities (e.g. managing credit risk, hedging interest rate risk) and utilities manage customer interactions (e.g. demand creation, quality assurance).
Because many households have long histories of paying their utility bills regularly, some financial experts believe that on bill repayment will reduce loan delinquency. On-bill financing for energy improvements is the most integrated with the savings those improvements are expected to deliver – which may help to alleviate consumer reluctance to take on debt to pay for them. Midwest Energy in Kansas operates a meter-attached residential loan program. If an individual doesn’t pay their bill and leaves the property, only the late payments at that point are uncollectible. Any remaining monthly payments transfer to the next customer at that meter. Over three years, the Midwest Energy program has issued about 600 loans for a total of more than $3.3 million in funding, and to date less than one percent of loans have been uncollectible (in line with the uncollectible rate of their other utility revenue).
Loan products that are paid off when properties transfer (Deferred Loans)
Some middle income households simply do not have the financial capacity to make consistent principal and interest payments on debt. This is especially true when the financed improvements lead to uncertain cash flow, or if building rehab needs to be funded in addition to energy upgrades, increasing net monthly payments. There are many housing and economic development agencies around the country that will fund home improvements through deferred loans – often health and safety-related rehab for fixed income seniors that have equity in their homes. No monthly payments are required, but a lien is attached to the property that must be paid off when the property is sold or otherwise transferred.
The Opportunity Council in Washington uses these deferred loans for repairs needed before free weatherization services to low income families. In Camden, New Jersey the city is using Recovery Act funds to create a revolving loan fund to offer residents a home energy upgrade, paid for with a deferred loan. The Wyoming Energy Savers (WES) loan program offers both amortized and deferred loans based on participant income.39 Those households earning less than 50 percent of AMI qualify for deferred loans, while those households earning 50-80 percent of AMI qualify for amortizing loans.40 Income-qualified households who are current on their mortgage are eligible for loans up to $15,000 for a list of pre-approved measures including heating equipment and weatherization measures. Deferred loans are offered at 3 percent interest due at time of home property transfer or sale.41 One key disadvantage to this product type is that borrowed funds are likely to revolve very slowly.
Paycheck-deducted financing involves repaying a loan through regular, automatic deductions from an employee’s post-tax paycheck. The Clinton Climate Initiative (CCI) is piloting a program called the Home Energy Affordability Loan (HEAL) in Arkansas,42 which allows employees of participating companies to finance energy upgrades with repayment through a payroll deduction.
Originally, the model entailed CCI providing technical assistance for companies to make energy efficiency improvements to their own facilities. These companies would then put a portion of the savings from these improvements into a revolving loan fund for employees. The employer-assisted model is still available, but CCI found that employee demand for financing was larger than the energy savings companies were realizing, and some companies have policies that preclude lending to employees. CCI developed a second model in partnership with local credit unions, in which a credit union, rather than the employer, provides the loan capital and loan repayment is deducted through payroll and automatically transferred to the credit union. For one pilot with the largest hospital in Arkansas, the hospital’s credit union is offering 5.75 percent interest for up to three years for unsecured loans to employees who have worked at the hospital for at least three years. The loans are unsecured, but the payroll deduction allows the credit union to do lighter underwriting and offer a lower interest rate than they would otherwise offer for standard unsecured loans.43 Beyond this security, some experts believe that households may be more likely to pay these loans because they are offered through — or are supported by — their employer, and they want to be seen as responsible employees and members of the company’s social community.
Property Assessed Clean Energy (PACE)
For those middle income households who have equity in their homes, PACE may be a promising financing tool if it gets past the current regulatory hurdles. PACE programs place tax assessments in the amount of the improvement on participating properties, and property owners pay back this assessment on their property tax bills. Like other property taxes, these assessments are treated as senior liens – which makes them very secure. PACE is debt of the property, which suggests that underwriting need not be based on a borrower’s personal creditworthiness (and that the financing can be transferred with the property) – potentially getting around the credit score and debt-to-income issues highlighted in this chapter. Residential PACE currently faces significant regulatory hurdles, which have largely eliminated its use around the country, pending court rulings or federal legislation…