Adverse Selection in a Model of Real Estate Lending

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Abstract
We provide a rationale for the presence of points in mortgage loan contracts. Our analysis builds on two key features. First, insurance markets are unavailable for labor income. Second, the “due‐on‐sale” clause allows banks to offer loan contracts which partially insure against fluctuations in labor income. If explicit prepayment penalties are prohibited by law, points serve effectively as prepayment penalties. We also examine environments where such penalties are not prohibited and show that points will be used if interest rates cannot depend on the size of the loan.

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