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An Analysis of Mortgage Contracting: Prepayment Penalties and the Due‐on‐Sale Clause
Author(s) -
DUNN KENNETH B.,
SPATT CHESTER S.
Publication year - 1985
Publication title -
the journal of finance
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 18.151
H-Index - 299
eISSN - 1540-6261
pISSN - 0022-1082
DOI - 10.1111/j.1540-6261.1985.tb04950.x
Subject(s) - prepayment of loan , loan , value (mathematics) , non conforming loan , business , loan sale , order (exchange) , actuarial science , cross collateralization , market value , mortgage underwriting , argument (complex analysis) , economics , finance , mortgage insurance , computer science , insurance policy , non performing loan , machine learning , biochemistry , chemistry , casualty insurance
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.