The Government said last week it would offer principal reductions for borrowers who are underwater (owe more than their homes are worth.)

The FHA plan is targeted at investors who currently own these underwater mortgages (see Negative Equity Share Chart below – source American Core Logic). Under the plan, the 1st mortgage holders would write down the principal of a first mortgage at least 10%. The loans would then be refinanced into FHA-insured mortgages as long as the loan to property value ratio is 97.75%.

For borrowers with second mortgages, total mortgage debt would have to be written down to a maximum of 115% of the home’s current value. The government would pay the holder of the second lien, but they are not mandated to do this.

To qualify, homeowners must be current on their loan, occupy the home as a primary residence, fully document their income and have at least a 500 credit score. However, expect the lenders to have a much higher credit score requirements – possibly 620.

Diana Farrell, a senior White House economic adviser, said the programs couldn’t be expected to prevent the majority of expected foreclosures. “The purpose is to deal with just enough of the overhang where we have a real chance of changing the dynamic,” she said.

The agency would take on more risk by refinancing underwater borrowers and that risk would grow if the program grows more successful. The Government said it would steer $14 billion in Troubled Asset Relief Program (TARP) funds that had already been allocated for foreclosure prevention to cover costs.

Note that it may take several months before it becomes available to borrowers. For more details – Read the Press Release and Consumer FAQs.