Bargaining, Mortgage Financing and Housing Prices

Abstract

Bargaining and mortgage financing have been extensively studied in the literature. However, they have only been studied separately. This paper is the first to embed financing into a bargaining model, and our model yields several new insights. First, we show that financing creates new ground for trading. In contrast to conventional wisdom, our model shows a buyer does not have to value a property more than its seller for a mutually beneficial trade to exist, and transaction prices are not bounded by the buyer’s and the seller’s valuations. It can be above the buyer’s valuation and below the seller’s reservation price. Second, our analysis shows that when financing is omitted in a bargaining model, the total gain from trade is incorrectly defined, and price is thus miscalculated. Third, our model can be used to analyze many commonly used financing arrangements in real estate transactions such as assumable loan, seller financing and seller-paid closing costs. Closed-form solutions of equilibrium prices are derived for various financing arrangements.

Keywords: bargaining; mortgage financing; housing prices

JEL Classification: G12; R21; C78