Abstract

This paper theoretically and empirically studies the interaction of search and application approval in credit markets. Risky borrowers internalize the probability that their application is rejected and behave as if they had high search costs. Thus “overpayment” may be a poor proxy for consumer sophistication since it partly represents rational search in response to rejections. Contrary to standard search models, our model implies 1) endogenous adverse selection through the search and application approval process, 2) a possibly non-monotone or non-decreasing relationship between search and realized interest, default, and application approval rates and 3) search costs estimated from transaction prices alone are biased. We find support for the model’s predictions using a unique dataset detailing search behavior of mortgage borrowers. Estimating the model, we find that screening is informative and search is costly. Counterfactual analyses reveal that tightening lending standards and discrimination through application rejection both increase equilibrium interest rates. This increase in realized interest rates is in part due to strategic complementarity in bank rate setting.