Fed leaves truth-in-lending rule to consumer agency

* Rule concerned borrower's ability to cancel a loan

* Consumer groups say it would hurt loan modifications

WASHINGTON Feb 1 (Reuters) - The Federal Reserve said on Tuesday it is backing away from a final rule impacting home foreclosures after consumer advocates said the reform would remove incentives to modify troubled loans.

The Fed said it will instead leave the issue for the new Consumer Financial Protection Bureau.

The Fed proposal would have made changes to the process where a borrower can seek to cancel a mortgage that violates disclosure requirements under a truth-in-lending law.

Under the current system, a borrower has up to three years to take a lender to court seeking to cancel a loan, through a process known as rescission, by showing that required disclosures about the terms of a loan were not provided when it was signed.

Once the loan is canceled, a borrower then has to pay off the principal, but can deduct from the total the amount that would have been paid in interest and other fees.

Lawmakers and consumer advocates charge the Fed proposal would make a key timing change requiring the borrower to pay off the loan before it is canceled. For details, see [ID:nN05289584]

In practice, groups opposing the rule change argue, struggling homeowners would lose leverage to renegotiate their loans because they would have to pay off the principal before a lender relinquishes their interest in the property.

In the proposed regulation released in September, the Fed argued the current system is confusing and said its proposal was an attempt to add clarity.

Under the new Dodd-Frank law, the authority over the truth-in-lending law moves to the new CFPB when it gets up and running in July.

The Fed said in a release that the agency determined it was best to wait for the new consumer agency to deal with the issue rather than put in place a final rule. (Reporting by Dave Clarke, Editing by Leslie Adler)