An Analysis of Mortgage Contracting: Prepayment Penalties and the Due‐on‐Sale Clause

  • Author(s): KENNETH B. DUNN, CHESTER S. SPATT
  • Published: Apr 30, 2012
  • Pages: 293-308
  • DOI: 10.1111/j.1540-6261.1985.tb04950.x

ABSTRACT

The due‐on‐sale clause contained in most conventional home mortgage contracts is equivalent to a prepayment penalty equal to the difference between the face value and market value of the loan. We analyze a bilateral game with asymmetric information and show that the bank demands the full penalty unless the market value of the loan is sufficiently low. In that case, the bank demands a prepayment penalty which is independent of the market value of the loan in order to induce additional prepayments. We also demonstrate, by a risk‐sharing argument, that the due‐on‐sale clause is optimal in some settings, even though it eliminates some beneficial home sales.

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