Mortgage in trouble? How Congress wants to help

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NEW YORK (CNNMoney.com) -- Politicians in Washington are busy arguing about the financial and moral hazards of coming to the aid of troubled homeowners.

But overshadowed by the debate over a proposal to let the government back risky mortgages is one important issue - how the program would actually work.

Who would qualify? What do borrowers and lenders have to sacrifice? How does the government get paid for its trouble?

The House last week passed a bill by Rep. Barney Frank, D-Mass., that would allow the Federal Housing Administration to insure new mortgages for people at risk of foreclosure. A key Senate committee is likely to take up a similar proposal this week. Final legislation could differ, but the House bill offers a sense of how the program could work if enacted into law.

What follows is an initial explanation based on the legislation and interviews with government and private-sector players. It uses a fairly probable scenario in a time of falling home prices - a borrower who is "underwater" and owes $220,000 on a home that is now appraised at only $200,000.

For homeowners to qualify under Frank's proposal, they must be full-time occupants of their principal residence. They also must have a mortgage debt-to-income ratio on their existing loan of more than 35%. So if the borrower above who owes $220,000 makes $4,000 a month, his monthly mortgage debt must exceed $1,400 to be considered for the program.

Participation is voluntary on the part of both lender and borrower. Either lenders will initiate contact with borrowers they believe may qualify, or borrowers may contact lenders, according to Steven Adamske, a spokesman for Frank. But it's the lender who will have final say over whether the borrower may participate.

For borrowers with second mortgages on their homes, such as home equity loans, the holder of that second lien must agree to eliminate that debt.

Even if borrowers are technically eligible for an FHA-backed loan, they can still be excluded if their lender believes other factors may make the borrower a bad risk. An oversight board will establish underwriting guidelines, but lenders are likely to have some flexibility.

"Nothing is ever written hard in stone," said Francis Creighton, vice president for government affairs at the Mortgage Bankers Association.

However, the bill specifies that no borrower may be turned away solely because they were delinquent on their existing mortgage or solely because of their credit score. The bill does not specify a minimum credit score qualification.

Both lenders and borrowers pay to play in the program. Lenders must be willing to accept no more than roughly 85% of the appraised value of the home by the time loan fees and closing costs are factored in. And they must make the FHA-backed mortgages 30-year fixed rates.

Here's how it works:

First, the lender writes down the principal to 90% of appraised value. That's the amount the FHA would guarantee - that is, the amount that the government would pay the lender if the borrower defaults on the new loan.

So, in the example above, the new loan would be written down to $180,000.

The remaining $20,000 - 10% of appraised value - would be the borrower's equity stake.

In addition, the lender must pay the FHA 3% of the loan amount ($5,400) to participate and up to 2% in closing costs ($3,600). So on top of forfeiting $20,000 in equity to the borrower, the lender pays $9,000 to the government up front.

The $29,000 the lender forfeits is 14.5% of the appraised value of the home, which means the lender is accepting in essence payment for no more than 85.5% of the home's value. In addition the lender has agreed to forgive the $20,000 in additional debt above appraised value from the original $220,000 loan.

For their part, while borrowers will get a 10% equity stake in their homes, they will have to pay for their participation in the program as well.

If the interest rate on a 30-year fixed rate mortgage is 6.50%, the borrower in this example will have a monthly mortgage payment of $1,138.

On top of that he will also have to pay a 1.5% annual premium to the FHA based on the principal balance of the loan, which will decline over time. That computes to $225 a month extra in the first year since his initial loan balance is $180,000.

Add to that property taxes (we assumed $167 per month) and home insurance (we assumed $50 per month), and his total housing payment every month would be $1,580.

The borrower will also be on the hook for an exit fee when he sells his home. The exit fee would be equal to the greater of 3% of the original FHA loan amount or a declining percentage of the net proceeds from the sale of the home. The percentage is 100% in the first year and falls to 50% by the fourth year and beyond.

Let's assume he sells the house after five years for $200,000. He would have paid down his principal balance to $168,500, leaving $31,500 for disbursement.

But he's not keeping the whole $31,500. He owes an exit fee to the FHA - in this case 50% of his net proceeds or $10,000. Since the house in this example sold for the same amount as its appraisal value five years earlier, the only net proceed is the borrower's 10% equity stake, or $20,000. So the borrower would pay half that to the FHA and walk away with as much as $21,500.

If the borrower sells his house below the appraised amount, he would still owe the FHA at least 3% of the original FHA-insured principal, or $5,400.

In the end, if the FHA plan becomes law, borrowers would have to decide if the program makes sense for them. They would have to consider a host of factors: whether they'd rather have a foreclosure on their record; how much they'll pay in program fees and insurance premiums; whether home prices are likely to go up, down or stay flat in the next several years.

"This is a difficult plan for borrowers to understand," Creighton said. "They'll need somebody very savvy to walk them through this."