What Is An Escalation Clause in Real Estate? Do I Need One?20 Oct Melody Keilig
An escalation clause, also known as an "escalator," is the section of a real estate contract stating that a potential homebuyer is willing to raise their offer if the seller receives a higher competing bid.
The escalation clause states how much more money the buyer will pay than the highest offer. These clauses are useful during bidding to give buyers a level of protection if their offer is outbid.
Typically, an escalation clause shows the seller how serious a potential buyer is about the property. Most of the time, an escalation clause states a limit of how much money the buyer is willing to pay to beat the other offers.
With an estimated over 50% of homes sales ending in bidding wars, it’s important to do everything in your power to score a house you really love.
How Does an Escalation Clause Work?
The main factors included in an escalation clause are the original purchase price, how high that price will escalate above a competing offer, and the maximum purchase price in the event of multiple offers. The clause will also include the amount the buyer will pay in increments if their offer is accepted.
An escalation clause occurs when the seller has proof of an offer from another buyer, which then makes the clause legitimate and enforceable. At that point, the seller cannot make up another offer.
Escalation Clause Example
So how does an escalation clause work? Check out this quick breakdown.
Let's start with Buyer 1, who submits an offer of $400,000. Next, Buyer 2 submits their offer of $405,000 with an escalation clause of up to $416,000 in $3,000 increments. Then, Buyer C submits an offer of $408,000.
Buyer 1's offer will not impact Buyer 2, but Buyer 2's escalation clause would bring them over Buyer C's offer. So, in the end, Buyer 2's final offer would be $410,000.
Buyer 2 is most likely going to get the home, but it's not a guarantee because the seller might choose to go with an all-cash offer even if the offer amount is lower.
When Should an Escalation Clause Be Used?
In a seller's market, escalation clauses can be quite beneficial. If homes are selling quickly, it's a good idea to make your offer stand out. This method helps in a competitive market, but it can also signal sellers that you mean business and are serious about buying a home. So if you're looking for the best chance to use an escalation clause, it's during a bidding war.
However, remember that escalation clauses are not entirely foolproof. Depending on your situation, it may not make sense for your needs. Speak with your real estate agent about whether the escalation clause would be in your favor in the local bidding war. It's also wise to decide how much money you're willing to spend on a home so you can have your potential offer ready if a bidding war begins.
Pros and Cons of an Escalation Clause
An escalation clause offers benefits and drawbacks, but each depends on your specific situation.
There are several advantages to using an escalation clause that can significantly benefit the buyer.
* Buyers will have more peace of mind about their offer. It's difficult enough to buy a home, not to mention in today’s extremely hot market. Rather than worrying about another buyer coming through with a higher counteroffer, you can rest easy with an escalation clause. Your clause will give you more buying confidence and ensure that you stay true to the budget you prepared in advance.
* An escalation clause makes the buyer's offer more attractive to sellers because it shows them that you are serious about purchasing the home. Therefore, the seller will likely consider the clause when selecting an offer.
* With a clause, the buyer doesn't end up overpaying for the home. When buying, you don't want to pay more than what the property is worth. An escalation clause can protect you from making too high of an offer because it will only increase if another buyer makes a higher offer.
Although escalation clauses have their pros, they also come with some cons.
Once an escalation clause is accepted, buyers and sellers lose their opportunity to negotiate. Because a clause reveals the maximum amount the buyer is willing to pay, the seller will know the highest offer from that buyer right off the bat. Which, in turn, eliminates the chance to negotiate. The cap limit might remove any bargaining power for the buyer, and a seller could reject the escalation clause and ask for the highest offer instead.
The sellers who accept escalation clauses cannot issue counteroffers to other buyers. Because some buyers may not be putting up their highest offer, sellers could automatically reject it.
An escalation clause can conflict with appraisals if their offer goes over the home's appraisal value. Because lenders are strict about how much money they will lend for a home, they require an appraisal to determine its market value and won't lend above that amount.
The clause can then lead to a tricky situation where the offered price for the home is too high and exceeds its appraised price. So although a buyer could win the bidding war, they could later find out that the lender won't give them sufficient funds to pay for the home.
How to Incorporate Escalation Clauses Into Your Offer
There are three things to include in your escalation clause, which are outlined below.
Escalation amount: The escalation clause should outline the price you want that will exceed the other offers. If your escalation amount is $8,000 and another buyer has an offer of $500,000, the new offer will be $508,000.
Price ceiling: This is the maximum amount you are willing to pay to buy the home.
Proof of offer: For the escalation clause to go into effect, the seller has to provide evidence of a competing offer. The proof of offer prevents them from using your escalation clause to make you overpay for the home.
Further, your escalation clause should indicate the original purchase price offer and the increments of which the offer escalates. Do note that the maximum purchase price should not exceed your preapproval letter.
Your escalation clause should require proof of a solid offer, which means that the seller cannot claim a higher offer that you must outbid. Because there is no legal requirement for the seller to let you know about other offers, you should ask for this information to be more informed about other potential buyers.
When the seller accepts an offer with an escalation clause, this becomes an agreement of a purchase and sale. So if there's a certain amount of money that you wouldn't feel comfortable paying, don't agree to a maximum price. Again, consulting your real estate agent and mortgage advisor is essential to ensure that your offer remains within your budget.
Tips for Success
When moving forward with an escalation clause, you must follow the process the correct way. Check out these tips as you take action for the best results when putting together an offer.
Be Realistic: When adding an escalation clause to your real estate offer, you should show the seller how serious you are about purchasing the home. It's also important to stay realistic about what you can afford, so stick to your budget.
To configure how much you can spend, select a price ceiling based on your preapproval letter and current finances. Even if your offer is as appealing as possible, it could always get outbid by another buyer.
Save the Escalation Clause for Your Dream Home: Although it can be tempting to use an escalation clause on every home you are interested in purchasing, you should save the clause for a genuinely loved home. Think of your dream home within your budget and use the clause sparingly for the property that fulfills your expectations.
Consider an Appraisal Contingency: If you ultimately decide to include an escalation clause with your offer, it's a good idea to add an appraisal contingency. This contingency states that once the home becomes appraised, it must meet the purchase price agreed on between you and the seller. By adding an appraisal contingency, you will avoid overpaying for the home.
Frequently Asked Questions
When inquiring about an escalation clause, you may have several questions that many other homebuyers have asked. Check out the most asked questions below!
How Do I Know My Price Ceiling?
When you include an escalation clause in your offer, it can be challenging to determine the price ceiling. Check out the two significant factors that can help in selecting the best maximum price for your budget.
First, your real estate agent will be able to assist you in determining the worth of a home. That's why it's essential to work with an agent to navigate through the process. Sometimes, if necessary, you can opt to pay more than the asking price but proceed with caution. For example, if you put a price ceiling that is much higher than the home's value, it might not be worth it in the end if you go beyond your budget.
Second, your preapproval letter from your lender states the amount of money you are authorized to borrow. Therefore, the price ceiling on your escalation clause shouldn't be any higher than the preapproved amount.
Can You Back Out of an Escalation Clause?
What happens if you change your mind after adding the escalation clause? Once you have the clause, it can be tricky to back out of your real estate contract, especially when your offer is accepted. Additionally, the seller may feel shorted out of the deal from accepting your offer over other bidders on the condition that you would be purchasing the home.
Your likelihood of backing out of the escalation clause also depends on the circumstances of your contract. For example, if you didn't meet certain contingencies outlined in the contract, you may have a legitimate case for backing out. But overall, it's crucial to speak with a real estate attorney to guide you through your options to ensure the best step forward.
Will The Seller Always Accept the Clause?
Although many sellers accept escalation clauses, not all sellers will take them. This reasoning is due to the seller wanting buyers to place their highest offer, which will make the bidding war more competitive.
Sellers who do not accept escalation clauses prefer that buyers submit their final offer first, especially in less competitive areas where the seller may receive one clause on the home. For example, if a buyer could have offered $416,000 but only escalated their price to $410,000, some sellers would prefer to get the higher price right away.
However, many sellers prefer having an escalation clause because it gets buyers into a bidding war frame of mind from the start and streamlines the paperwork.
How Do I Calculate an Escalation Clause?
When calculating your escalation clause, remember that there is no set number for clause increments. Although, you will want to set reasonably high increments so you can stand a chance of outbidding other offers while looking competitive, all while sticking to your budget.
The amount of your increments will escalate your offer depending on how aggressive you want your bidding to be. Two significant factors to consider when calculating your escalation clause are precise comparative market analysis (how much the home is worth) and the number of liquid assets you have to cover a low appraisal. For example, if the listing price is $600,000 and you have $30,000, a better escalation could be around $630,000.
Is An Escalation Clause a Good Idea?
Because the buyers' offers are immediately apparent to the seller, the escalation clause can speed up and simplify the homebuying process. This way, the seller doesn't have to refer back to each buyer's agent to ask for the new highest bid.
So is adding an escalation clause to your offer a good idea? If you're in a competitive market, and you really want the home, the clause is worth your time to decrease your odds of getting outbid. Utilizing the escalation clause is a great home buying strategy to give you a much better chance of purchasing your dream home.
Adding an escalation clause can benefit you as a buyer during the highly competitive market we're facing this year. However, there are some drawbacks of this clause as covered above. Discuss the best option going forward with your real estate agent, and they will have the expertise to guide you through the process of whether an escalation clause will give your situation an advantage, or not.
For more home buying tips and tricks to win over sellers, check out BHGRE HomeCity!