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

Abstract

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.