The legislation, approved 93-1, would allow the Federal Housing Administration to back refinanced loans for borrowers who are delinquent on payments because their mortgages are resetting to sharply higher rates from low initial "teaser" levels.
The bill also tries to make FHA loans more attractive than risky subprime loans by accepting lower down payments and expanding the eligibility for counseling for homeowners having difficult with their mortgage payments.
An estimated 2 million to 2.5 million adjustable-rate mortgages are scheduled to reset in the next year, jumping to much steeper rates that could cost borrowers their homes. The wave could crest during the presidential and congressional election campaigns next year, and politicians have been wrestling with what the government's response should be.
The Senate's proposed changes are especially important now, given the credit crisis that has made it much more difficult and more expensive for people to refinance or get financing to buy a home. Private lenders have been reluctant to make new loans.
Allowing the federal government to insure more and bigger loans should help provide some relief and ease the credit crunch.
The Senate's plan would give homeowners "the option of refinancing to an FHA-backed loan with the peace of mind that comes with it," said Senate Majority Leader Harry Reid, D-Nev. "And for future homebuyers, a fully backed FHA loan with honest, upfront terms, will help prevent crises like we now face."
Modernizing the FHA is Congress' first attempt at stand-alone legislation to ease the subprime mortgage mess. The House passed a bill similar to the Senate's back in September, but a final measure probably won't be ready for President Bush's signature until next year.
Meanwhile, the White House last week announced it had negotiated an agreement with mortgage companies to freeze interest rates for certain subprime mortgages for five years.
White House press secretary Dana Perino said the Senate bill "would give FHA some of the additional flexibility it needs to provide more families with a safe, affordable mortgage financing option." She said, however, that the president still has some concerns about the bill.
The Senate bill raises the maximum mortgage the FHA can insure in high-cost areas like California and the Northeast from $362,790 to $417,000 the same level as loans backed by Fannie Mae and Freddie Mac.
The House would raise the maximum mortgage to $729,750 in high-cost areas, with the higher limit a point of contention between the House, Senate and the White House.
The Senate bill would also lower the FHA down payment requirement from 3 percent to 1.5 percent, depending on an assortment of factors, and make it easier for FHA loans to be used to buy condos.
"It is good before the Christmas season we have made a down payment on the solution to this problem," said Sen. Mel Martinez, R-Fla.
The legislation will help the FHA "be a source of salvation for those families who were tricked into unaffordable loans," said Sen. Charles Schumer, D-N.Y.
The only senator to vote against the bill was Sen. Jon Kyl, R-Ariz.
"With the mortgage market already in turmoil as a result of too many mortgages being made available to those who cannot afford them, now is not the time to relax standards even further and make taxpayers liable if borrowers default," Kyl spokesman Ryan Patmintra said.
Many homeowners have been looking for help from the government this year. Of the nearly 3 million subprime adjustable-rate loans surveyed by the Mortgage Bankers Association in the third quarter, a record 18.81 percent of them were past due. A record 4.72 percent of the loans entered into the foreclosure process during that period.
Modernizing the FHA "will have an immediate impact helping some distressed borrowers who are having trouble paying their current mortgages avoid foreclosure," said David G. Kittle, the association's chairman-elect.
The nonpartisan Congressional Budget Office estimated that the Senate's changes would result in an 8 percent increase in FHA loans
$4 billion annually in additional loan guarantees over the next five years.
The agency, which has provided mortgage insurance since 1934, currently insures 3.7 million mortgages.
The FHA has been pushing Congress for years for the ability to guarantee more loans, saying the size of mortgages the government agency can back is often too small to attract borrowers in expensive areas. As a result, FHA's share of the single-family mortgage market has dropped to about 4 percent, down from 19 percent more than 10 years ago.
But most of the increase would not come from people in high-cost areas, the CBO said, but in the less expensive housing markets, where maximum mortgages would be going up from $200,160 to $271,050.
The Senate also passed legislation that would allow homeowners to receive mortgage forgiveness from their lender tax free. That's when a lender allows a homeowner not to pay a portion of their mortgage.
The IRS currently taxes any loan forgiveness as income. The tax forgiveness is available on mortgage indebtedness of up to $1 million.