Underwriting guidelines are a central aspect of any residential energy efficiency and renewable energy loan program, establishing the criteria the lender will use to determine creditworthiness and the eligibility of prospective borrowers to receive a loan.
The loan program example discussed here is "unsecured," meaning that the lender does not take out a lien on the property as security, and no appraisal of the property will be required, although other forms of security may be necessary. State and local governments and their financial advisor(s) should negotiate the underwriting guidelines with the financial institution partner(s), which is a critical aspect of setting up a clean energy loan program.
Issues Covered During Underwriting
Underwriting takes into account the following issues:
- The energy efficiency equipment that contractors install as part of the lending program has low-to-no collateral value, so in essence the financial institution's credit analysis looks to the borrower's ability to pay and willingness to pay
- "Ability to pay" is the core of the credit analysis for unsecured residential energy efficiency loans. This is determined principally through the borrower's credit score, debt-to-income ratio, and confirmation of steady income. Debt-to-income (DTI) ratio is calculated using total debt service and gross income. A typical ratio is 40% to 50%; but state and local governments can argue for and some lenders have agreed to higher DTI ratios, given the fact that energy cost savings from the energy efficiency/renewable energy project will improve the homeowner's ability to pay. In some markets, the acceptable DTIs are as high as 45% to 50% for residential energy efficiency loans. Minimum FICO credit scores vary by financial institution partner—some financial institutions look for a minimum of 680 to 700; others accept a minimum of 640 or lower. For unsecured loans, some financial institutions may require fixture filing (UCC-1) on project equipment.
- "Willingness to pay" is enhanced by the fact that the energy equipment is "essential use" for property owners: it is what keeps their home comfortable. In many cases, homeowners cannot live in the house without the equipment in question—furnaces, air conditioners, etc. Credit analysis examines the combination of ability to pay (income and debt to income ratios) as well as willingness to pay (borrower bill payment history). Both are important to the credit analysis.
- Lenders may file a UCC-1. This creates a lien on the installed energy efficiency equipment itself. That lien does not allow the lender to foreclose on the property, but the lender can, in theory, repossess the equipment or deny beneficial use of the equipment in event of loan default. While this remedy is unlikely to be exercised, the UCC-1 does have other benefits. In the event of property sale, transfer, or mortgage refinancing transaction, the lien will appear in the title search and will need to be cleared or resolved as a condition of the transaction. Thus, the lender can get repaid in such circumstances. Many lenders feel that a UCC-1 fixture filing is costly and not worth the time or money to file because it results in very little additional security in the event of default especially in the case of most energy efficiency installations; repossessing insulation is almost impossible, for example.
- State and local governments and the homeowners they hope to assist in their energy efficiency/renewable energy loan programs should be aware that some financial institutions do like to file a deed of trust, which represents a lien on the real property; however, the financial institution would be "last in line" to collect, after any other first or second mortgage payment. Some financial institutions will do this even without conducting property appraisals or applying any loan-to-value criterion.
Note that most financial institution partners do not expect or set, as part of the underwriting guidelines, a loan-to-value criterion (referring to the real property appraised value and total mortgage debt outstanding on the part of the homeowner). However, financial institutions can and do apply an additional interest rate premium if they feel that the clean energy lending program places their lending capital at a high risk.