As of June 25, 2018, we’ve made some changes to the way our mortgage approvals work. You can read more about our Power Buyer ProcessTM.
If you’re looking to buy a home right now, you’ll want to have a few tricks up your sleeve to stay ahead of the competition. One trick you could pull out of said sleeve is called an escalation clause.
What Is an Escalation Clause?
The simplest way to describe an escalation clause is the current bid compared to the maximum bid on an eBay item you’re trying to buy. Hypothetically speaking, if you wanted Pharrell Williams’ brown fedora, you could have placed a bid of $40 on it when it first went to auction. But since you know that a lot of other people would probably want that infamous brown fedora, too, you might put a higher maximum bid on it. That’s your escalation clause. The escalation clause you would have needed to win that brown fedora would have had to have been over $44,100 if you wanted to beat Arby’s winning bid.
There’s more to it than that, and we’ll get into it. But that comparison is a start.
How Do Escalation Clauses Work?
When buying a home, your escalation clause would be set up to increase your offer in predetermined increments whenever someone else bids until you have the highest offer on the home. It should also have a maximum or a ceiling that would prevent the offer from increasing to an amount you can no longer afford. In my earlier example, if you bid $40 on Williams’ fedora and put an escalation clause on it without a ceiling, you’d be on the hook to pay over $44,100 after the bidding was done.
When Should I Use One?
You should use an escalation clause – or at least talk to your real estate agent about getting one – when you’re in a seller’s market (periods of time where there are more buyers than sellers) and you expect multiple offers to be made on a home that you have your heart set on.
How Do I Put an Escalation Clause in My Offer?
Simply put, talk to your real estate agent about it. Mindy Jensen, a licensed agent in Colorado and community manager at BiggerPockets (a real estate social networking platform), says, “Your agent will add the clause into the contract as an addendum, but you should direct the agent or at least ask them their opinion about an upper price limit. You don’t want to sign a contract that says you will offer up to $350,000 if you can only afford and be approved for a loan for $320,000.”
How Do I Determine the Price Ceiling?
There are two big factors that can help you find out what that upper price limit, or ceiling, should be:
First: Your Real Estate Agent
Your agent should have a good idea of what the house is worth and how a more competitive market like the one we’re in now may impact that home value. Trust your agent here. You can pay more than the asking price if needed, but do so with caution and within reason, as putting a ceiling on the escalation clause that is significantly higher than the value of the home may not be worthwhile.
Second: Your Preapproval Letter
Your preapproval letter shows you and your agent how much you’re qualified to borrow from the lender based on the lender’s guidelines. The ceiling on your escalation clause should not exceed the amount you can get financing for.
What Do I Need to Watch Out for with an Escalation Clause?
Your escalation clause essentially tells the seller the amount you’re preapproved for and/or the maximum amount you’re willing to pay for the home.
Jensen says, “Many times, the escalation clause will require proof of the other offer that kicked your clause into effect.” This piece is key. It requires the seller to show proof of the competing offer that made yours increase, which protects you from a seller who might see the maximum you’re willing to pay and try to counter your offer with that amount.
One other thing to look out for is the potential for the seller’s agent to ask you to guarantee the price from your escalation clause even if the house appraises for less. Jensen explains, “When the housing market is so hot that properties are consistently selling for above asking price, the appraisals may not keep up with the market. Some agents representing the seller will ask you to guarantee the price you are offering – even if the appraisal doesn’t support it.”
What Do I Do if I Need to Back Out of My Escalation Clause?
Jensen explains that there are a few things you could do if you absolutely need to back out of your clause: “If the seller’s agent does not require you to guarantee the offer price if it doesn’t appraise, you can typically get out of the contract using any of your other contingencies.”
She also says, “If you win the bid, then immediately decide you do not want the property at that price, you can cancel the contract by not giving earnest money, which voids the contract if it isn’t received in a timely manner.”
Jensen’s biggest piece of advice to homebuyers, though, is not to make an offer that you can’t (or won’t want to) follow through with. “Allowing your emotions to direct your bidding isn’t the best way to purchase a home.”
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