Chari is from the Research Department, Federal Reserve Bank of Minneapolis; Jagannathan is from the Department of Finance, University of Minnesota and the J. L. Kellogg Graduate School of Management, Northwestern University. We would like to thank Anjan Thakor for useful comments. All errors are our own. This research was supported in part by the Banking Research Center, Northwestern University. Ravi Jagannathan gratefully acknowledges support from a grant by the McKnight Foundation to the University of Minnesota. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
Adverse Selection in a Model of Real Estate Lending
Article first published online: 30 APR 2012
1989 The American Finance Association
The Journal of Finance
Volume 44, Issue 2, pages 499–508, June 1989
How to Cite
CHARI, V. V. and JAGANNATHAN, R. (1989), Adverse Selection in a Model of Real Estate Lending. The Journal of Finance, 44: 499–508. doi: 10.1111/j.1540-6261.1989.tb05069.x
- Issue published online: 30 APR 2012
- Article first published online: 30 APR 2012
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.