July 14 (Bloomberg) -- The Federal Reserve tightened its mortgage rules by requiring lenders to determine a borrower's ability to repay and barring other practices that led to the collapse of the U.S. housing market.

The Fed Board of Governors voted in Washington today to require that lenders verify a homebuyer's income or assets, and create an escrow account for property taxes and homeowners' insurance. The rules curb penalties for repaying a loan early.

``It seems clear that unfair or deceptive acts and practices by lenders resulted in the extension of many loans, particularly high-cost loans, that were inappropriate for or misled the borrower,'' Fed Chairman Ben S. Bernanke said today at the meeting.

The Fed is responding to criticism from Democrats in Congress who blame the central bank for neglecting its authority to protect consumers from unfair mortgage and credit-card lending practices. The Fed adopted the rules under authority it won 14 years ago.

U.S. foreclosure filings rose 53 percent in June from a year earlier, with one in 501 U.S. households entering the foreclosure process, RealtyTrac Inc., a seller of default data, said July 10. Foreclosures climbed as adjustable-rate mortgages reset, and property owners were unable to keep up the payments.

``These changes have made for better rules that will go far in protecting consumers from unfair practices and restoring confidence in our mortgage system,'' Fed Governor Randall Kroszner said.

Prepayment Penalties

The rules ban prepayment penalties on loans whose payments can change during the first four years, and limit such charges to the first two years on other types of subprime mortgages.

Prepayment penalties are fees lenders charge borrowers who pay their mortgages early, usually to refinance into a less expensive loan. Consumer groups say the fees trap borrowers in mortgages they can't afford to repay. Lenders say the charges let borrowers pay lower interest rates and make mortgage-backed securities more valuable to investors.

The Fed declined to ban all prepayment penalties after a Columbia University study showed that borrowers with such penalties on fixed-rate mortgages paid lower rates of interest, Kroszner said in a briefing with reporters after the meeting.

The rules take effect Oct. 1, 2009. They won't apply retroactively, said Kathleen Ryan, counsel for the Fed's consumer and community affairs division.

Broker Fees

Bernanke questioned a staff recommendation not to ban a practice that lets lenders pay brokers based on the interest rates they charge a consumer, which he said sets an incentive for brokers to steer people into more expensive loans.

``Staff considered a rule that would ban that type of payment, but we ran into some serious, practical problems,'' Ryan said. She said it would be difficult to distinguish between legitimate payments to brokers and fees intended to land a borrower in a higher-cost mortgage.

Allen Fishbein, director of housing and credit policy at the Consumer Federation of America, said the Fed should have banned the broker payments along with prepayment penalties.

``This whole area of steering still needs to be addressed,'' Fishbein said. The rules ``will provide some new protection for consumers taking out subprime loans.''

Mortgage companies have modified practices in line with the Fed's rules, Steve O'Connor, senior vice president of government affairs at the Washington-based Mortgage Bankers Association, said in a telephone interview. ``The Fed codified in its rules a lot of what the market has done.''

Lending Patterns

O'Connor said the group is concerned the Fed dropped language from its proposal that would have required a borrower to prove a violation by showing that a lender had a pattern of writing unaffordable loans. O'Connor said the change ``lowered the bar to potential litigation.''

The Fed issued the rules using authority under a 1994 law aimed at protecting consumers in mortgage lending. Senate Banking Committee Chairman Christopher Dodd, a Connecticut Democrat, had prodded the Fed to write the new regulations.

``I'm impressed that they proposed these ideas and I welcome it,'' Dodd said today in a conference call with reporters. ``We still want to look at those more carefully.''

To contact the reporter on this story: Alison Vekshin in Washington at avekshin@bloomberg.net.

Last Updated: July 14, 2008 15:32 EDT