In the world of real estate, cash buyers enjoy a reputation for speed, certainty, and simplicity. According to a new study, that’s not all they enjoy: on average, they simply pay less for properties. This phenomenon, known as the mortgage-cash premium, amounts to just over 10% and presents a puzzle for economists and policymakers alike.

The Premium Explained

Imagine you’re selling your home. Two offers land on your desk: one from a cash buyer, the other from a mortgaged buyer. Despite the mortgaged buyer offering a higher price, you hesitate. Why? Mortgage-financed deals come with risks, including potential transaction failure and longer closing times. To offset these risks, mortgaged buyers often must bid higher than cash buyers.

This discrepancy isn’t trivial. The study by Reher and Valkanov found that between 1980 and 2017, sellers consistently required an average 11% premium from mortgaged buyers. On a $500,000 home, this translates to a staggering $55,000 difference.

“When sellers accept a mortgage offer, it comes with risk,” said Michael Reher, study co-author and assistant professor of finance at the Rady School of Management. “There is a risk the deal will fall through because there’s a third-party mortgage lender who needs to approve the loan for the borrower and there are other caveats such as issue the appraisal, or inspection, which is why around 10% of transactions fail when the buyer is paying with a mortgage. We find sellers are willing to leave money on the table to avoid the risk.”

Why Cash Buyers Pay Less

Cash buyers dominate approximately one-third of U.S. home purchases. Their appeal lies in their simplicity: no lenders, no lengthy approval processes, and fewer contingencies. This makes cash offers particularly attractive in high-risk markets where sellers prioritize speed and certainty.

Economists use models to explain pricing behaviors, and the mortgage-cash premium appears excessive when compared to typical transaction frictions. A dynamic seller model, which accounts for failure risks and delays, predicts a much smaller premium of 3%. The remaining 8% constitutes what the researchers call a “price puzzle”.

This puzzle is partially explained by heterogeneity in selling conditions. Sellers in high-risk scenarios, such as during economic downturns or when facing financial constraints, may demand steeper premiums. But even accounting for factors like this doesn’t explain the entire observed price difference. This is where the new study comes in.

The study incorporated surveys of 3,400 U.S. homeowners to explore seller psychology. Results pointed to ambiguity aversion—a behavioral tendency where individuals prefer known risks over unknown ones. Sellers, for instance, may demand a higher premium for mortgaged buyers due to uncertainty about whether the deal will close successfully.

This insight helps bridge the gap between theoretical models and real-world behaviors. Sellers in uncertain markets, faced with ambiguous risks, inflate premiums to mitigate potential losses. Ambiguity aversion, therefore, amplifies the perceived friction of mortgage transactions.

A shifting premium

The mortgage-cash premium isn’t static. Mortgage rates today influence the premium, as do broader market dynamics Higher rates can increase transaction failure risks, exacerbating sellers’ concerns. In such environments, sellers may demand even steeper premiums from mortgaged buyers, further widening the gap between cash and finance offers.

Conversely, when mortgage rates are low, mortgaged buyers may appear less risky, reducing the premium. Policymakers could leverage these insights to stabilize housing markets by addressing underlying frictions.

The mortgage-cash premium has significant implications for housing affordability and policy. U.S. taxpayers subsidize trillions in mortgage debt to promote homeownership, yet these subsidies don’t fully address the market’s pricing inefficiencies. Reducing transaction frictions, such as through faster approval processes or better loan guarantees, could lower the premium and make homeownership more accessible.

“Considering that about a third of home purchases are all-cash deals, these differences are highly relevant for real estate market participants,” said Rossen Valkanov, study co-author and professor of finance for the Rady School.

Moreover, addressing ambiguity aversion might involve better educating sellers about the actual risks of mortgage transactions. Transparency about buyer qualifications and lender reliability could also build trust and reduce unnecessary premiums.

Implications for everyone

The problem is also important at the national level.

“In policy terms, U.S. taxpayers subsidize $8 trillion of mortgages to promote home-ownership,” Valkanov said. “If policymakers made it easier for mortgage buyers to close escrow, it could be a more cost-effective route to promoting home-ownership than subsidizing mortgages for first-time home-buyers.”

The study highlights the complexity of real estate transactions and challenges long-held assumptions about market efficiency. By unraveling the psychological and economic drivers behind the mortgage-cash premium, it paves the way for smarter policies and a fairer housing market.

Whether you’re a buyer navigating today’s mortgage rates or a seller weighing offers, understanding the factors behind this premium is essential. As the housing market continues to evolve, so too must our approach to ensuring equity and efficiency.

Journal Reference: The Mortgage-Cash Premium Puzzle, The Journal of Finance (2024). papers.ssrn.com/sol3/papers.cf … ?abstract_id=3751917