Typical Underwriting Guidelines and the Loan Loss Reserve Fund Impact
Underwriting guidelines are a central aspect of the residential energy efficiency and renewable energy loan program, establishing the criteria the lender will use to determine creditworthiness and thus the eligibility of prospective borrowers to receive a loan.
The loan program discussed in this guide 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. Grantees and their financial advisor(s) negotiate the underwriting guidelines with the financial institution partner(s); doing so and doing it well is a critical aspect of setting up a clean energy loan program.
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.
“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 (fixture filing). 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 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.
Grantees 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.
Typically, the underwriting guidelines address the following:
Confirmation of income
Debt-to-income (DTI) ratio, which is calculated using total debt service and gross income. A typical ratio is 40% to 50%; but grantees can argue for and some FIs 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 that 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.
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.
Impact of the Loan Loss Reserve Fund on Standard Underwriting Guidelines
Grantees can use loan loss reserve funds (LRFs) to persuade lenders to offer more flexible terms. The availability of an LRF can have these benefits:
Reduces required credit score. Minimum qualifying credit scores of as low as 600 exist in some programs
Increases debt-to-income ratio. Typical ratios will be from 40% to 50%.
Lengthens loan tenor. Loan tenors are typically up to 10 years, although in some cases FIs may be willing to offer longer loan tenors.
Allows larger unsecured loans. High loss reserves can convince lenders to offer unsecured loans in excess of $20,000, although a cap on unsecured lending of $15,000 to $20,000 is typical.
Increases or eliminates the loan-to-value criterion and any requirement for property appraisal. Both of these are taken for granted in a typical “unsecured” loan situation without an LRF.
Reduces or eliminates required customer capital contribution
Lowers the interest rate.
Standard Underwriting Guidelines for Secondary Market Development
The U.S. Department of Energy is supporting work to develop a standard set of underwriting criteria for the secondary market. These criteria would create a standard loan product that is uniform enough for secondary market investors to understand its risks and consider a purchase of the loan product. See Lending Program Options in the Primer on Lending section for descriptions of some typical criteria.