Colorado has issued an emergency rule banning prepayment penalties on adjustable-rate mortgages. The state alleges mortgage brokers who originate these loans with prepayment penalties are not acting in the best interest of borrowers.

The state's division of real estate director, Erin Toll, issued an emergency rule prohibiting prepayment penalties that extend beyond the rate adjustment date or payment adjustment date, according to an announcement from Colorado Governor Bill Ritter.

"When their rates increase, they may find stiff prepayment penalties if they attempt to pay off their loan by selling their home or refinancing," the statement said. "Their only option is foreclosure."

The statement said Toll was acting on the concerns of Ritter, state legislators and consumer groups.

The rule, which took effect on Friday, is based on the presumption that brokers somehow violate their fiduciary responsibility to borrowers by recommending ARM loans with the penalties.

A number of enforcement actions taken by Toll in the year since she took over the job were also touted in the announcement.

"Along with our aggressive enforcement actions against those who participate in unlawful actions that encourage foreclosures, this is another step to attempt to stem the wave of foreclosures," she said in the statement.

Prepayment penalties have historically been used by lenders to offer a low rate on a new ARM -- often below the lender's own costs -- because they knew they would eventually become profitable when the rate adjusted higher. By banning prepayment penalties, the state will likely reduce refinancing options even further for an already tight credit market.

Toll told MortgageDaily.com that the penalty only applies to new loans and not loans already on the books.

She said she doesn't think the rule will negatively impact the availability of credit.