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

Kenneth B. Dunn and Chester S. Spatt
The Journal of Finance
Vol. 40, No. 1 (Mar., 1985), pp. 293-308
Published by: Wiley for the American Finance Association
DOI: 10.2307/2328061
Stable URL: http://www.jstor.org/stable/2328061
Page Count: 16
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An Analysis of Mortgage Contracting: Prepayment Penalties and the Due-on- Sale Clause
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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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