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Running head: PRICE ELASTICITY OF DEMAND IN MORTGAGE PRODUCTS

Price Elasticity of Demand in Mortgage Products Roger ³Chip´ Browne Stevens-Henager College

Price Elasticity of Demand in Mortgage Products The concept of price elasticity in economics can be applied to either the demand or the supply of a good or service. The price elasticity of demand is a measure of the quantity demanded of a good or service relative to a change in its price. The price elasticity of supply is a measure of the quantity supplied of a good or service relative to a change in its price. This paper will focus on the former, the price elasticity of demand. The demand for a good or service is said to be inelastic when the price elasticity of demand is less than one. A 1% change in price yields a smaller than 1% change in quantity demanded. Changes in price have a relatively small effect on the quantity of the good or service demanded. The demand for a good or service is said to be elastic when the price elasticity of demand is greater than one. A 1% change in price yields a greater than 1% change in quantity demanded. Changes in price have a relatively large effect on the quantity of the good or service demanded. In this paper, I will select a product which is currently sold by my mortgage brokerage, and I will discuss if the pricing of this product has a high or low elasticity of demand. The Characteristics of a Residential Mortgage Loan A residential mortgage loan has several characteristics. A residential mortgage loan is first categorized by its program and term. The programs that are currently available to me from the wholesale lender are conforming loans, super conforming loans and Jumbo loans with durations of 10, 15, 20, and 30 years. The wholesale lender also offers several interest rates with accompanying discount points or rebates associated with each interest rate. The loan amount is another characteristic. The purpose of the mortgage loan is another characteristic and can be a purchase transaction, a refinance with cash out or a refinance with no cash out. The loan-to-value or LTV is another characteristic of a residential loan. Another characteristic is whether or not the

lender shall be collecting monthly costs for annual home insurance premiums and annual property taxes. Another characteristic of the residential loan is the credit FICO score of the loan applicant. Another characteristic is the number of units of the residence and whether or not the occupancy is owner occupied, a second home, or an investment property. Another characteristic is the combined loan-to-value or CLTV. Another characteristic is the length in days of the lock on the interest rate. The final characteristic of a residential loan is a property type which can be singlefamily, condominium, PUD, or to 2-4 family. The Cost of a Residential Mortgage Loan Affluent Capital, LC is a mortgage brokerage licensed to operate in the state of Utah. I am the principal lending manager of this mortgage brokerage. Currently, the only product that my mortgage brokerage sells is a residential mortgage. The price of a residential mortgage depends on several characteristics. The wholesale lender with whom I work determines the costs depending on the combination of characteristics for a particular mortgage loan applicant and collateral property. In addition, there are several third party providers including a title company, a credit reporting company, an appraiser, a loan processor and more whose fees are added to the cost of the loan. Finally, my fee as a mortgage broker is called the loan origination fee, and it is the only fee over which I have control. The total cost of the residential mortgage loan is the sum of the costs or rebates from the lender, all these third-party provider fees, and my loan origination fee. Residential Mortgage Loansand the Price Elasticity of Demand Is the demand for a residential mortgage loan inelastic or elastic? Do the changes in price of a residential mortgage loan have a relatively small effect on the quantity of residential mortgage loans demanded?In order to determine whether or not the demand for a residential loan is inelastic

or elastic, it would be necessary to have statistical information which documented the impact on quantity demanded of a 1% change in the costs of securing a residential mortgage loan. I do not have this information, but I can use the qualities of both inelastic and elastic products or services and compare them to residential mortgage loans. The Effect of the Market Interest Rate In analyzing whether or not the demand for a residential mortgage loans is inelastic or elastic, it must be explained that the market interest rate of the loan has a relatively large effect on the quantity of residential mortgage loans demanded. When interest rates are low, individuals seek to refinance their existing financing. In addition purchase transactions increase for a similar reason. When interest rates are high, refinancing activity decreases, and new purchase transactions reduce. New-home buyers may choose to rent and so the purchase when interest rates are high. One may conclude that the demand for a residential mortgage loan is elastic because the demand for loans increases when the interest rate decreases, and the demand for loans decreases when the interest rate increases. Effect of Closing Costs on the Demand of a Residential Mortgage Loan The costs incurred for securing a mortgage loan are independent of the interest rate of the loan. Costs are, however, factored when calculating the annual percentage rate which is a more accurate interest rate which factors in an amortization of the costs of obtaining the loan. If the costs associated with securing a mortgage loan were increased or decreased, would there be a relatively large or small effect on the demand for residential mortgage loans? My response to this is that there is a relatively minor impact upon the demand for residential mortgage loans when the costs of securing a mortgage loan are increased or decreased. Closing costs are like a necessary

surcharge when obtaining a product. Closing costs could be compared to sales tax for example. The overall demand of residential mortgage loans is not impacted by changes in closing cost. Final Analysis of Price Elasticity of Demand for Residential Mortgage Loans In the final analysis of whether or not the pricing (interest rate and closing costs) of a residential mortgage loan has a high or low elasticity, it is necessary to ask the question if consumers will purchase less residential mortgage loans when the price is high and more residential mortgage loans when the price is low. The price of a residential mortgage loan involves the market interest rate and the associated closing costs. In order to accurately measure elasticity of demand, it would be necessary to have statistics which measured the number of close residential mortgage loans compared to both the interest rate and closing costs. Although I do not have access to this information, I conclude that mortgage loans that are related to refinancing increase when mortgage rates decrease and decrease when mortgage rates increase. I've also concluded that residential mortgage loans for purchase transactions are relatively independent of changes in interest rates.Closing costs are a necessary expense. The interest rates of residential mortgage loans, therefore, demonstrate elastic characteristics, and the closing costs of a residential mortgage demonstrate inelastic characteristics.

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