The Equilibrium Distribution of Prices Paid by Imperfectly Informed Customers in the Mortgage Market

This document made my brain hurt. Anyway, good info…

Consumers often transact with imperfect information about the best price available for a product. Some examples are mundane, a grocery shopper does not know the price of Kleenex at every other nearby grocery store. Others are more substantial, such as the best available price for a particular new car or the best expense ratio for an S&P 500-indexed mutual fund. We consider a large expenditure that the majority of consumers make every 5 or 10 years, the payment at the closing for a mortgage. These payments range from zero to $30,000 for mortgages of normal size. They are called  origination fees” or  points” or a myriad of other terms; often the borrower pays for several di erent categories. Occasionally a borrower receives money back as negative points.” Because consumers enter the mortgage market infrequently and because of features of the market that make it difficult to learn the best price, mortgage pricing is a leading example of a market where many consumers pay well above the best price.

Earlier research has shown that mortgage charges are higher for less educated borrowers, members of minorities, borrowers who pay high interest rates, and those who borrow larger principal amounts. The research has not shown whether the borrowers paying higher charges did so because arranging the mortgage cost more or because those borrowers su ered exploitation of their lack of knowledge of the best available charge, which should be little higher than cost. We use a novel identi cation strategy to achieve that separation. We show that the groups of borrowers who pay higher charges are more costly to serve, but that part of the higher charges they pay go to mortgage brokers as pro t rather than as compensation for higher cost. Our ndings are relevant for policies on mortgage disclosures. Borrowers with better information can bargain for lower charges, but only down to the level of cost. Disclosure policies should alert borrowers to the bene ts of learning about the best deals available. We develop a model that demonstrates the potential ampli cation of the favorable influence of better informed borrowers, if borrowers find out better deals from their friends, each borrower who shops more e ectively conveys an external bene t on future borrowers who learn from the borrower about better deals.

We are concerned mainly with closing charges rather than with mortgage interest rates. The reason is that we lack an observable benchmark for the rate that a consumer should choose. Cash-constrained borrowers should pick a higher interest rate, as we demonstrate.We develop an Edgeworth-box analysis of the bargain between a lender and a borrower. There is a unique interest rate that de nes the location of the contract curve, but the cash paid at closing is a lump sum that depends on the bargaining powers of the two parties. Our analysis is the standard one for two-part pricing, adapted to the speci cs of the mortgage transaction.

We focus on mortgages arranged through brokers, because the wholesale value of a mort-gage is known for these mortgages. We take the minimum upfront payment for a mortgage to be the broker’s transaction cost of around $2,400 less the di erence between the proceeds from the loan and its wholesale value. The broker receives that di erence as the so-called yield-spread premium, which is often the majority of the broker’s compensation. Thus, if a borrower pays $1,500 as a closing payment, receives $100,000 from the lender at the closing, and the wholesale value of the loan (the present value of the borrower’s expected payments) is $97,700, with a yield-spread premium to the broker of $100,000…

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