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In a surprise move that could lower thousands of homeowners’ monthly mortgage payments this year, the nation’s largest investor in home loans wants to require automatic cancellation of mortgage insurance coverage when borrowers build up substantial equity stakes in their properties.

The proposed policy change by Fannie Mae, outlined in a confidential memo distributed to a small group of mortgage companies late last year, would also require that consumers with insured loans owned by Fannie Mae be notified in writing at least once a year about their rights to terminate mortgage insurance payments, and how to apply to do so.

Fannie Mae’s proposal attempts to defuse one of the most contentious issues in the home mortgage field during the past year: Millions of dollars of payments by homeowners for loan insurance long after the economic need for such insurance has passed. The controversy has produced over two dozen class action suits against major mortgage companies, several of which ended in settlements on the behalf of borrowers. It has also attracted attention in Congress, where legislators have considered requiring disclosure and mandatory termination of insurance coverage when requested by eligible borrowers.

At the center of the issue is a product that millions of homeowners pay for every month private mortgage insurance or “PMI” but that is widely misunderstood. Often adding $50 to $100 onto homeowners” monthly mortgage payments, PMI is required by most lenders whenever the borrower obtains a loan with less than a 20 percent down payment.

The insurance protects the lender or the ultimate purchaser of the loan, like Fannie Mae against financial loss in the event of a borrower’s nonpayment of principal and interest.

Should a borrower default and the house go to a foreclosure sale the insurance policy pays the lender’s costs to some specified coverage level. Since the risk of loss declines once a borrower has built up at least a 20 percent stake in the property, some lenders and investors permit termination of monthly insurance payments at that point, provided the borrower files a written request.

But many borrowers are unaware of their rights to seek cancellation, and continue paying for coverage far longer than necessary, In one case cited by PMI critic Rep. James V. Hansen, R-Utah, a borrower continued paying insurance premiums for over 20 years, when her equity stake approximated 90 percent.

Fannie Mae, along with its mega-investor rival, Freddie Mac, allows borrowers to request PMI termination under certain circumstances. But neither giant has ever required its mortgage servicers to monitor Loans, and to terminate collection of premiums automatically at any point. Nor have they required that consumers be informed systematically of their termination rights.

Fannie Mae’s draft policy memo, written by senior vice president Robert J. Engelstad, would change this dramatically in 1997. For starters, all 2.3 million borrowers holding Fannie Mae mortgages with PMI would receive annual disclosure statements explaining the conditions under which their insurance payments could be ended.

For some borrowers, the termination would be automatic, requiring no request on their part. To be eligible for automatic termination. borrowers would have to have maintained an “acceptable” payment record no 30-day-late monthly payments during the previous 12 months, and no 30-to-59-day-late payments during the previous two years.

Their loans would also have to have reached a minimum age: at least seven years old for a mortgage with a 15-year or less original term to maturity; or at least 10 years of age for a loan with an original term of more than 15 years.

Other categories of borrowers with “acceptable” payment histories could request termination on their own. If homeowners believe their equity stake has reached 20 percent of the original value of their property, they could contact their mortgage service and request termination. The minimum equity standard would be higher 30 percent for borrowers whose properties are used as second homes or rented out as investments.

Borrowers who believe market appreciation or improvements have increased the value of their equity significantly could also apply for insurance termination. Under this “current value” option, borrowers with loans two to five years of age would have to meet a 25 percent minimum equity standard; borrowers with loans five years of older would have to meet a 20 percent equity test. To establish current market value, an appraisal typically would be required at the applicant’s expense.

Sources at Fannie Mae cautioned that the Engelstad proposal are still in the negotiation stage with mortgage servicers and won’t be firmed up until late February. Moreover, sources said, the proposal with the biggest potential impact on borrowers the automatic monitoring and termination plan would not take effect until this summer. After that, however, eligible homeowners with Fannie Mae-owned loans could well start receiving surprise good news in the mail notifications that mortgage insurance no longer is required and that their monthly payments will be reduced immediately. Any excess funds escrowed for PMI would be refunded or credited.

Tax relief

Besides capital gains relief on the profits when they sell their residences, American homeowners can look forward to several other tax-related benefits that appear likely to flow from the Republican-controlled Congress.

The capital gains planks of both parties have been widely publicized since last summer’s campaign conventions. Both proposals would allow owners to pocket up to $250,000 of home sale gain (for singles) or $500,000 (for joint-filers) tax-free.

Congress is also expected to consider approving tax relief for owners who incur losses when they sell their houses.

Under current law, when you sell a house for a big loss because the local market cratered, you get no tax relief. That’s because losses on home sales don’t count as capital losses for federal tax purposes.

That would change under legislation by Rep. Bill Archer, R-Texas, that would allow you to treat your home sale losses as capital losses.

Kenneth R. Harney writes for the Washington Post Writers Group. Regular columnist Jane Bryant Quinn is on vacation.