The Time Value of Money and the Energy Efficient Mortgage
Let me ask you a question: Would you rather I gave you $100 one year from now or $100 right now? No brainer; it's easy to see that $100 right now is worth more than $100 in the future. Another way to say that is $100 in future value is worth less than $100 in present value. But what if I told you that I'd give you $100 one year from now or $90 today? Which would you take?
As it turns out, financial analysts, those other folks who like numbers, have figured out how to calculate the breakeven point. You can tell them a future value number, and they've got a formula you can use to calculate how much it's worth in today's dollars, the present value. They just need two other numbers to figure it out: the interest rate and the period of time involved.
Here's the forumula:
If I give you $100 in one year (n = 1), and the interest rate, i, at which you could have invested that $100 now is say, 3%, your present value would be $100 /(1+0.03)^1 = $97.09. You can change the interest rate and the amount of time and see how the present value varies.
What happens, though, if it's not just a single payment that you get in one year? Let's say you're going to get $100 every year. Those crafty financial guys have that one figured out, too.
Cool! The only new variable here is A, which was called FV in the other formula. You're summing up the annual payments for a given number of years, n, and finding the cumulative present value due to all those payments.
But what's it good for?
The Energy Efficient Mortgage (EEM) and present value
The HERS Standards discuss present value (as well as another cost effectiveness measure called Savings Investment Ratio, or SIR) in chapter 3, the technical standard. This is because home energy ratings exist mainly because of the effort to give credit to buyers of energy efficient homes for the savings they realize. The HERS Standards (download pdf) are titled, Mortgage Industry National Home Energy Rating Systems Standards, after all.
This present value calculation is enormously important for the Energy Efficient Mortgage, which has many benefits. In fact, when you look at the numbers, it's really baffling that these things aren't being written in huge numbers every month. (You can download the slides from a webinar I did with Jason Payne of EEM Training in 2011 to learn much more about how they work and see a powerful case study.)
Anyway, to get an EEM to improve an existing home (sometimes called an Energy Improvement Mortgage, or EIM), the HERS rater finds the present value of the energy savings due to improvements they model. Then they compare two numbers: the present value and the cost of the improvements.
Net Present Value = Present Value - Cost of Improvements
This equation tells you how much of your future money you can spend now without going in the hole. If the result is a positive number, the modeled improvements are deemed to be cost effective and can be included in the loan amount for an EEM (within the bounds of the EEM guidelines, of course). As long as your net present value is zero or positive, you're at least breaking even.
If you're like me, when lenders start talking, your eyes glaze over and they seem to be talking alienese. If they talk about present value, though, it's really a pretty simple concept. An important one, too. If you're looking to buy a home or refinance the home you're in, you really ought to check out whether an EEM makes sense for you. It's not that hard to have a positive net present value with older homes.
To learn more about present value and EEMs, download our webinar slides.
Photo by TheAlieness GiselaGiardino²³ from flickr.com, used under a Creative Commons license.