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Chapter 23: The TRUTH About HERO loans

An in depth examination of the benefits and pitfalls of this new home improvement financing gadget

Background

The HERO loan is a “private label” for a PACE loan. They are the same thing. The concept of the PACE (Property Assessed Clean Energy) program began in northern California, in San Francisco in 2001 and in the Monterey Bay in 2005. California passed the first piece of legislation or PACE financing and started the Berkeley FIRST climate program in 2008. Since 2008, legislation enabling PACE programs have now been passed in more than 31 states. The legislation is popular because it allows for bond financing for the purpose of immediately paying for energy efficient improvements to commercial and residential properties.

As it relates to residential property, the distinct difference between a PACE loan and other secured liens on the home is that legislation allows the PACE loan to become part of the property tax assessment. Since property taxes take priority over first mortgages in a foreclosure, PACE loans are referred to as “super-superior liens.”
When a homeowner accepts this financing option, the new loan just “slips right under” the first mortgage and saddles up next to the property tax assessment! This is legal, and mortgage lenders are not too happy about it because it increases their risk of loss. Should the property fall into foreclosure and get sold, delinquent property taxes and the PACE loan would get paid first. Then the lender would be 3rd in line to eventually receive their share.

PACE loans, or tax assessments, are said to be a debt on the house, not a debt of the homeowner. Unlike a homeowner’s mortgage and home equity line that would absolutely have to be paid off during a home sale, the PACE obligation stays with the house. This could potentially encourage homeowners to make immediate improvements rather than hold off because they are uncertain about how long they will own the home and whether they will recoup their investment in the home.

Cisco DeVries is the godfather and inventor of the PACE loan, according to Renew Financial, a company he runs in Oakland, CA. However, the king of the hill appears to be a Notre Dame grad named J.P McNeill, who helps run Renovate America out of San Diego. This company has been the most aggressive marketer of any loan I’ve seen since the 125% loan, which allowed a homeowner to borrow more than their home was worth. Using the popular NFL quarterback Dan Marino as their TV pitchman, First Plus became the dominant player in the 125% loan market, before it crashed.

In walks The HERO

Renovate America has private labeled their PACE loan calling it the “Award-Winning HERO™ Program,” which stands for Home Energy Renovation Opportunity (HERO). This company appears to be dominating the market. From public records and online interviews, it appears they have raised at least $148,959,090 in unregistered securities offerings. In an interview published on cleantechies.com, they appear to be generating a 4.75% securitized return on that capital. That would technically represent the investors return on the money they raised. They are charging their homeowners from 6.75% into the 8.00% range. That doesn’t calculate the A.P.R. (Annual Percentage Rate) either, which is much higher, thanks to HERO administration program costs and other fees. Presumably, their gross profit margins before operating costs would be the difference between the 4.75% and the average A.P.R. on their loans – pretty healthy gross margins!

The advantages that the HERO front line sales mechanism presents:

The primary distribution channel of PACE / HERO loans is through home improvement contractors. The clients I have worked with have received sales presentations in their homes from these contractors. One of the advantages of the PACE / HERO program presented by the contractor’s sales force would certainly be the outright ability to easily qualify for the loan. HERO loan qualifications have no credit score requirement. Therefore, homeowners with lower credit scores, who may not qualify for other financing alternatives, may be able to qualify for a PACE / HERO loan. That can certainly be viewed as an advantage if you don’t have the cash to pay for solar panels or a new roof or other energy efficient home improvements.

Another advantage presented would be the tax advantage. As with mortgage financing, the ability to itemize and deduct the interest (along with your property taxes) on your tax returns might be considered a big advantage, especially for those homeowners in slightly higher tax brackets. Because of the PACE loan’s “attachment” to the home’s property taxes, effectively integrating the entire loan and its repayment into the property tax payments, a PACE loan appears attractive compared to other forms of financing that have no current effect on a homeowner’s income taxes.

Some might even make a far reaching comparison of the mortgage interest deduction vs. the PACE loan property tax assessment (deduction). Some might conclude that not only is the interest tax-deductable, but so is the principal repayment as well, which is not the case with a mortgage. Unlike a mortgage company that always sends a year-end Form 1098 “mortgage interest paid” statement for tax purposes, HERO loan borrowers do not receive any similar year-end statement. They are left with only their closing documentation and annual property tax bills as ammunition for tax preparation.
Intuit, the software giant that sells the Turbo Tax software, has this to say on its website regarding HERO loan tax deductions, “According to page 151 of IRS Publication No. 17, the principal portion of the payment is deductible for repairs, but not for improvements.” On many projects, I could imagine this distinction getting a little fuzzy at tax time. Will this set up borrowers for a potential IRS audit problem, or will it serve as a bigger tax advantage used by borrowers and CPAs? The answer appears unclear and without case history.

Furthermore, the tax assessment and payments facilitate an amortized payment plan that will pay off the lien during the defined term, so lots of principal reduction is included in the annual assessment (payments). This theory of utilizing principal payments in the tax deduction may be a stretch in some circumstances but not without precedent.
When Mello Roos assessments first entered the picture over two decades ago, the real estate community cautioned homeowners about deducting the Mello Roos portion of tax payments on their tax returns. Everyone I have ever encountered did take those deductions, even though they are technically a very small portion of a bond payment. Those bond payments obviously include principal and amortize as well. Technically, the homeowner is getting a deduction on the principal reduction component of the payment, whereas that is not the case with a mortgage payment, where only the interest is tax deductable. I’m not aware of any negative consequences from declaring those deductions. Be advised, we are not offering tax advice, so be sure to consult your tax professional on this matter.

Another “advantage” presented by the contractors could be that the obligation or assessment stays with the property, so it can technically be transferred to the new owner. (However, there might be some serious issues with this assumption!) This aspect of the financing may appeal to homeowners who have an unclear time frame about how long they intend to own the home. If they are undecided about staying in the home long enough to recoup their investment in the project, this potential benefit might be tipping point that facilitates the sale, especially with solar panels which are so popular.

Again, PACE / HERO loans are primarily sold by home improvement contractors. In many of the cases my clients have been involved in, the sales process was initiated by a “door to door” solicitation, generating their interest to pursue a home improvement project. This tactic represents an “old school,” direct sales scenario, almost similar to the days of selling vacuum cleaners door to door to stay-at-home house wives. This practice certainly wouldn’t occur in a gated, million dollar home community, where solicitors can’t enter and buying decisions often occur without the help of a salesman and with thorough online research ahead of time.
As a contractor, if you’re going to send “door knockers” into the field, you would want to use tools and products that would generate the maximum amount of business. The PACE / HERO program works like a charm and “sells like hot-cakes” in neighborhoods with entry level priced homes and homeowners who may not have perfect credit. This is also our market! Active military families and Veterans using their VA home loan benefit to buy homes are very often first time home buyers who don’t have perfect credit. These contractors appear to be targeting “FHA & VA neighborhoods.”

I have a tremendous respect for the sales profession and the complicated process of moving goods and services from point A to point B. Frankly, everybody sells. Infants begin selling to their mother from birth and perfect those skills through their youth as they ask for what they want and argue their case as teenagers! I have a pretty clear understanding of how these home improvement sales scenarios utilizing HERO loans play out in real time. It can be easy to generate interest and more convenient to sell benefits to a customer in need when only the “surface level” advantages are presented. Often the disadvantages are not mentioned, and the customer is on their own to discover the pitfalls of their decision after the sale.

Disadvantages of the PACE / HERO financing sales mechanism

There are several disadvantages of this product and its distribution system. As a homeowner with a PACE / HERO loan attached to the home, you can’t utilize conventional financing to refinance, and your buyers can not use it to purchase, which may stop a home sale. Many FHA & VA lenders have also adopted the same position, declining loan applications on homes with a PACE / HERO loan attached. In addition to those show stoppers, the interest rates and fees are relatively high, compared to other secured lien mortgage products.

Unfortunately, in 100% of the cases that I have evaluated with my clients, the borrowers were not truly informed of all the long-term consequences of accepting a PACE / HERO loan to finance their home improvement projects. They also didn’t spend the time to compare financing options on their projects. In addition, they thought that there was no effect at all on their opportunity to refinance. And they were not aware of any effect that the PACE / HERO loan may have on the future sale of their property.

Because the main distribution channel for HERO loans seems to be through contractors, this sales mechanism can result in surprises to the homeowner. Renovate America partners with contactors and offers them “exclusive discounts and rebates,” so they can “close more deals,” according to the website. The business model is terrific, and I applaud its success, but the homeowners need to be made aware of the potential consequences of their financing decision during the sales process.
During the sales presentation, contractors are primarily focusing on selling their company and the benefits of their home improvements to the homeowners. After that portion of their presentation, they sprinkle the “sugar on top,” selling the features or advantages of the HERO loan, such as easy qualifying and tax benefits. From the standpoint of selling benefits to the homeowner, the contractors have been handed a terrific new “tool in their box.” Selling a home improvement project just got easier with no credit requirements and enhanced tax benefits! It’s not surprising that the contractors leave the disadvantages out of the sales pitch.

Many products that contractors are selling fill a need in an emergency, such as heating and air conditioning or a new roof, perhaps before the winter rains. Naturally, homeowners are looking for a way to solve their emergency problem quickly, as opposed to giving a lot of consideration to financing alternatives. And typically, the homeowner who needs financing as opposed to paying cash for a repair is the homeowner with a lower credit profile. And the same homeowner with lower credit scores is going to be a better prospect for a PACE / HERO loan.

Disadvantages of the PACE / HERO financing product

Is I stated, you’ll have potential problems with any new financing on the home, and PACE / HERO rates and fees are high. There is a significant amount of back story on this problem that could put you to sleep with the detail. Included in the back story are colorful events such as a lawsuit filed on whether the agencies Fannie Mae and Freddie Mac had the right to decline financing on properties with PACE / HERO loans. California Governor Jerry Brown sued the Federal Housing Finance Agency (FHFA) to overturn its decision support the agencies’ position. In 2013, a federal appeals court upheld the Agency’s right to prevent the government sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, from buying loans involved in this program.

FHFA was established by the Housing and Economic Recovery Act of 2008 (HERA) and is responsible for the effective supervision, regulation, and oversight of the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Home Loan Bank System. They essentially play “mortgage king” overseeing a majority of our real estate financing system.

After PACE loans became popular in California, primarily through the aggressive marketing from Renovate America to promote their HERO program, a decision was rendered and announced by the FHFA. Below is the conclusion of their position and a statement (WARNING) to homeowners considering PACE / HERO financing:
Statement of the Federal Housing Finance Agency (FHFA) on Certain Super-Priority Liens
FOR IMMEDIATE RELEASE
12/22/2014
In issuing this statement, FHFA wants to make clear to homeowners, lenders, other financial institutions, state officials, and the public that Fannie Mae and Freddie Mac’s policies prohibit the purchase of a mortgage where the property has a first-lien PACE loan attached to it.  This restriction has two potential implications for borrowers.  First, a homeowner with a first-lien PACE loan cannot refinance their existing mortgage with a Fannie Mae or Freddie Mac mortgage.  Second, anyone wanting to buy a home that already has a first-lien PACE loan cannot use a Fannie Mae or Freddie Mac loan for the purchase.  These restrictions may reduce the marketability of the house or require the homeowner to pay off the PACE loan before selling the house.
FHFA believes it is important for states and municipalities to understand these restrictions before continuing to offer the programs.  Additionally, FHFA believes that borrowers should fully understand these restrictions prior to taking out a first-lien PACE loan.

As you can see from the statement, the “800 lb. gorillas” in the mortgage marketplace have taken a strong position regarding PACE / HERO loans. If for any reason a property suffers a foreclosure, Fannie’s and Freddie’s lien position, and therefore their security, is compromised with a PACE / HERO loan on the home. So the FHFA has opted out! But what about the government loans, FHA & VA?

More disadvantages to PACE / HERO loans: FHA and VA lenders choose sides

Ultimately, a process known as securitization drives mortgage lenders’ guidelines regarding how to package home loans. Since Lew Ranieri of Solomon Brothers invented mortgage-backed securities more than three decades ago, lenders sell loans to Fannie Mae, Freddie Mac and GNMA (pronounced “Ginniemae”), the Government National Mortgage Association. These three buyers make up a large majority of the mortgage loan volume in the U.S. Lenders sell mortgage loans to these agencies and replenish their capital. These agencies aggregate (securitize) billions of dollars in loans together, and they sell the payment streams to institutional investors, replenishing their capital.

While FNMA and FHLMC purchase the conventional loans, GNMA purchases nearly 100% of FHA and VA loans. GNMA provides lenders basic underwriting guidelines of how to package these loans. FHA mortgage insurance and the VA Loan Guaranty Certificate work very differently in how they provide lender protections against loss due to foreclosure. Therefore, the underwriting guidelines to prepare an individual loan for funding and sale to GNMA differ from FHA to VA. On top of that, lenders must manage risk in their own individual ways, as they see fit. As we have witnessed, it’s a risky business. Remember all the foreclosures from the financial crisis of 2008? Lenders lost billions. Let’s now briefly examine the history of how FHA and VA lenders address a property when a PACE / HERO loan enters the picture. How does this affect you, the homeowner?
July 19, 2016, FHA Mortgagee Letter 2016-11: FHA has provided “clear guidance” regarding this tricky topic. “Properties which will remain encumbered with a PACE obligation may be eligible for FHA-insured mortgage financing, provided that the mortgagee determines that the following requirements have been met.” While the details of this policy are tedious, the story unfolds in an interesting manner.

July 19, 2016, the Department of Veterans Affairs, Circular 26-16-18: The VA states an identical position, including:
“b. The property may be subject to the full PACE obligation; however, the property shall not be subject to an enforceable claim (i.e., a lien) superior to the VA-guaranteed loan for the full outstanding PACE obligation at any time.
c. The property may, however, be subject to an enforceable claim (i.e., a lien) that is superior to the VA-guaranteed loan for delinquent regularly scheduled PACE special assessments. (Note: If VA acquires ownership of a property that is subject to a PACE obligation, or if VA is assigned a VA-guaranteed loan that is secured by such a property, nothing in this policy should be construed as a waiver or release of VA’s federal property rights or legal claims related to such property rights.)”
In my opinion, these statements from FHA & VA seriously conflict with the original state legislation that provides for PACE financing. I’m not a real estate attorney, but in a foreclosure, it’s not immediately apparent, whose lien is senior. Both parties seem to be making a claim to that position. I think many lenders seem to agree with me, because I have personally surveyed the lenders who buy our loans after they have funded, and a large majority won’t touch a FHA or VA loan when a PACE / HERO loan exists on the tax assessment! This doesn’t bode well for you as the homeowner trying to sell or refinance when financing options are seriously constricted.

More than a year and a half of pain for our VA borrowers

The VA Loan Guaranty only offers protection for the lender on the first 25% of the loan balance. In that manner, the loan guaranty substitutes for the down payment in a conventional scenario. It reduces the lender’s risk, but it doesn’t eliminate it altogether. Once the FHFA Statement was issued in December 2014, lenders offering VA loans adjusted their underwriting guidelines prohibiting the existence of PACE loans on the property, effectively eliminating the possibility of our VA borrowers to combine their home loan benefit with PACE on a new VA loan.

As rates continued to drop, legions of VA borrowers responded to lender’s solicitations to use VA streamline refinancing (VA IRRRL) guidelines to easily lower their interest rates. Imagine the disappointment of those men and women who served and now had PACE / HERO loan, when a VA loan professional told them, “I’m sorry sir, you’re stuck because you got the HERO loan.” I was the one making that statement many, many times. That was reality for every VA refinance prospect in that situation.

At that time, if the VA client wanted to take advantage of lower mortgage rates, the PACE / HERO loan would have to be paid off with a larger VA cash-out refinance loan. To qualify, the VA borrower needed adequate credit and enough income to support the larger debt load. They also had to have enough equity to include both the existing first mortgage and the PACE / HERO loan in the new loan balance, not to exceed the new appraised value.
AND HERE IS WHERE IT GOT THE UGLIEST: If the homeowner was not receiving disability payments from the VA (and exempt from paying the VA funding fee), the fee tacked on another 3.3% on top of the of the new base loan amount. And that could be a significant sum to repay. In nearly all cases that I worked with, the HERO loan killed the deal one way or another.

Since July 19th 2016, a limited number of lenders have decided to take the risk and to make FHA and VA financing available, only if the PACE / HERO lender will record a document know as a “Subordination Agreement.” This document officially releases the “senior lien claim” of the PACE / HERO loan and purportedly puts the new FHA or VA loan in “first position.” Again, a majority of the lenders I work with will not make the loan, but the Renovate America website states that they may subordinate the lien. Again, this is a dicey, grey space without legal precedent. And none of this has been tested in a declining value market. In a declining market with increasing foreclosures, I think this story of opposing interests between FHA / VA lenders and PACE lenders will produce another chapter. As foreclosures potentially mount, the boxing gloves from both opposing entities will undoubtedly appear as each party strives to protect their financial interests.

Disadvantages of PACE / HERO loans when trying to sell your home

If you are trying to sell your house, the existence of a PACE / HERO loan presents problems. What if your buyer wants to use conventional financing? You’ll have to pay off the PACE / HERO loan during the closing of the sale. What if the value of your home (including the improvements paid for by the loan) is not enough to allow the PACE / HERO loan to be paid off during the sale? Closing costs to sell the home must also enter the equation. Your sales price must accommodate your mortgage payoff, the PACE / HERO loan payoff and your closing costs. If your sales price is not high enough, you will have to write a check to close the sale. If you can’t write the check, you’re stuck in the house or looking for another buyer who will use other financing.

Again, if the buyer’s lender chooses not to make loans on a home with a PACE / HERO loan attached to the tax assessment, your home buyer won’t be able to get financing. You won’t be able to sell your house to that buyer!

High interest rates and fees on a PACE / HERO loan

Compared to the old finance companies like Household Finance and Beneficial Finance, PACE / HERO loans are cheap. But those companies are long gone, and compared to current mortgage products, those loans are EXPENSIVE! With rates from 6.75% into the 8.00% range, the HERO loan rates are very high. Currently, that’s double the rate of what a first mortgage charges. And the fees are high enough to be illegal, if it was a mortgage product. “QM” (Qualified Mortgage) guidelines require qualifying mortgages to have fees less than 3.0% of the loan amount. “Outdated” CA-AB489 California statutes required mortgage loan fees to be 5.00% or less than the loan amount.
When trying to help clients refinance, I have reviewed HERO documentation demonstrating HERO loan fees between 6.50% - 9.0% of the loan amount. If we use a standard A.P.R. (Annual Percentage Rate) calculation and a comparison, it would be obvious that the high loan fees dramatically increase the cost of borrowing. As an example, on one client’s HERO loan that was paid off on 12/5/2016, the HERO loan fees were $1,783.81 on loan proceeds of $19,900. That’s a whopping 8.964% of fees on top of the amount that was available for the client to utilize.

On another client’s HERO loan that was paid off on 11/28/2016 (using a VA cash-out refi):
  • The loan amount proceeds were $42,699, and additional HERO loan fees were $2,793.05.
  • The NOTE Rate was 6.50%.
  • A 60 month term would result in a payment = $985.44.
  • If an A.P.R. were calculated on this data, it would be 9.44% - that’s HIGH!
That is a “finance company rate,” similar to a used car loan for a borrower with a credit score of less than 580. Considering this loan is a “super lien,” and extremely well “secured,” in my opinion, Renovate America is “killing it,” CRUSHING IT…knocking it out of the ball park in every way with their business! Again, my congrats gentlemen.

Well, it is legal. Finance companies, like Household Finance have been doing it to consumers (including Veterans) for literally more than a century. Household Finance used to knock on doors to generate home improvement financing business. Sound familiar? In some cases, providing credit to those borrowers who can’t otherwise access credit could be considered a valuable service. As a Veteran, please do your homework to determine if it’s right for you.

Paying off a PACE / HERO loan during a refinance… be prepared for surprises

I've paid off a number of HERO loans and it’s a huge hassle for everyone, especially the client, and especially during the property tax season when taxes are due. In California, property taxes are due on November 1st and delinquent on December 11th. Estimating the new VA cash-out refinance loan amount and managing the possible property tax refunds from the HERO loan and the county tax assessor’s office is difficult for the inexperienced.

You may have to pay your HERO loan property tax assessment THREE TIMES OVER and then have to wait for multiple refunds. It does happen. If the closing of the refinance is in November, and the escrow officer cannot confirm that your current loan servicer has paid the property taxes now due, then the taxes (with the HERO assessment) must be paid through the closing of your refinance. If it’s in late November, it’s likely that the loan servicer HAS paid the property taxes as well. So they get paid twice. On the second payment received by the county tax assessor’s office, they should send the funds back from where they came as the first refund. And it’s a BIG one, because it has the HERO assessment included!

It gets worse. The HERO loan administrators will issue a payoff statement for escrow to respond to. That payoff will include not only the principal, but also the interest, administration program cost, county recording, processing and “other fees.” In this payoff statement, there exists a significant redundancy of the amount paid in the county tax assessment, which of course includes the HERO loan assessment. If it were not “property tax season,” (11/01-12/10), this would be a non-event. The HERO loan would get fully settled – period. But during property tax season, the title company MUST pay the tax assessment due to the county (or confirm that the current loan servicer has paid them) on a refinance per the new lender’s instructions. The payoff of the HERO loan doesn’t exclude that requirement.
In this circumstance, the county gets their taxes twice and the HERO assessment gets paid THREE times. Follow the money... The payoff from escrow directly to the HERO loan administrators makes the outstanding HERO loan balance zero and pays all the itemized HERO loan fees, most of which were included in the original contract. The county tax assessor’s office received two payments for one tax bill, so escrow or the previous loan servicer (the check that was received second by the county) should receive a refund from the county. This refund for the duplicated tax payment (including HERO), must go back to the homeowner. This is the first large refund the client must track. And finally, according to a well trained HERO customer service agent, there’s a refund from the HERO loan administrator that must be tracked.

The HERO loan administrator receives a payment from the county which collects the funds as part of the assessment, right? But, the HERO loan has now been paid in full by escrow, so the HERO tax assessment got paid twice. A refund is due to the homeowner who must wait approximately three months to receive it! This is a bit insulting considering the payoff statement from the HERO loan administrator includes interest payable WAY BEYOND the date of payoff, effectively acting as an early payoff fee! The payment from the county gets issued to the bank which handles the cash flow and accounting on the HERO loan’s “asset-backed security.” This is a block of HERO loans all packaged together. The overpayment of this homeowner’s account ultimately gets discovered and then the funds meander their way back to the patient homeowner. WHEW!

Getting the impound account correct on the new VA cash out refinance loan that pays off HERO…a small challenge that creates delays…and the delays don’t stop there!

Hopefully your VA loan professional can handle the minor issues! Educating escrow officers, mortgage loan underwriters and loan document preparation clerks is necessary to the successful funding of new loan that pays off a PACE / HERO loan. I have not witnessed one person who subtracted the HERO tax assessment OUT of the new escrow impound account, without a specific request. They look at the title report, see the “excessive tax amount,” and without considering that the HERO loan is being paid off, they include the HERO tax assessment in the new impound account and resulting payment. Each time, they need to be reminded to take the HERO assessment back out of the equation. I have even had funding delays because of appraisals being prepared “subject to” the HERO special assessment being paid off. This confused the funder who asked for an additional inspection that wasn’t necessary. Paying off these loans is a new process – a hassle!

After PACE / HERO loans get paid off. Are there more problems on the horizon?

Tax assessment and resulting first mortgage loan payment problems may occur for homeowners even after the PACE / HERO loan is paid off. In some circumstances, the tax assessments recorded and continually updated at the county assessor’s office likely won’t update fast enough for all client circumstances. Imagine this scenario: Using the only available property tax assessment, which is now too large and “outdated” and includes the now paid off PACE / HERO loan, the new loan servicer is likely to overpay the property taxes due February 1st, delinquent April 11th.

They won’t have a choice. They will get the “current” tax bill which still includes the PACE / HERO loan assessment, and they will pay it. This will likely create some problems for some clients as their new escrow account on their new loan immediately goes into a deficit and the loan servicer subsequently sends them a letter notifying them of the option to increase their payment or write a check!

Evaluating PACE / HERO loans and their advantages and disadvantages is a complicated process. The decision to use this financing can only be concluded after consulting professionals who truly understand all aspects of this equation. For assistance in making this important decision, feel free to call So Cal VA Homes at (949) 268-7742.

Call a Sr. VA Home Loan Technician today!

(949) 268-7742

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