What Is An Escalation Clause, And Should You Use One When Making An Offer?
If you’re looking to buy a home, you’ll want to have some tools at your disposal to stay ahead of the competition. After all, nobody wants to find their dream home, only to lose it in a bidding war.
One effective strategy for avoiding this scenario is what’s known as an escalation clause. Let’s explore what an escalation clause is and when it makes sense to use one. It’s a vital tool for a home buyer, capable of helping them compete against another buyer’s offer.
What Is An Escalation Clause?
A section in a real estate offer, lease or other type of real estate contract, an escalation clause – also called an escalator clause – guarantees an increase in an agreed-upon price once a specific factor has been determined. Applied to real estate and real estate offers, an escalation clause says that if a competing offer is made on the property, such as in the case of a bidding war, your bid will automatically increase by a certain amount of money to surpass the new offer.
For instance, an escalation clause may state that you are willing to pay a certain price for a home. But if a competing offer is received, you’ll raise your offer up to a predetermined limit.
An escalation clause is typically added when a buyer and their real estate agent assume that a property will receive multiple offers. It’s a good way to attempt ensuring that your bid is the highest bid on a property.
The clause sounds simple in theory, but in reality, a number of details must be worked out. And even if you add an escalation clause to a contract, it’s not a guarantee you’ll get to buy the property.
How Does An Escalation Clause In Real Estate Work?
If you’re buying a home in a competitive real estate market, an escalation clause in your offer can increase your chances of outbidding other home buyers.
When determining whether to include an escalation clause consider the seller’s asking price, the incremental amount you’re willing to pay to outbid other buyers and the maximum amount you can afford on a home.
Additional considerations may include market conditions, like how competitive the market is and how many other homes are available for sale.
Example Of An Escalation Clause
Let’s say you find a great home for your family and make an offer of $250,000, but the neighborhood is in high demand and you suspect that this home may receive multiple offers. So, you add a clause stating that if someone outbids you, you’ll exceed any other offers by increments of $5,000, up to a $270,000 highest offer.
Typically, an escalation clause is set up to gradually increase your offer in predetermined amounts whenever someone outbids you. In this example, your offer will increase in increments of $5,000 every time a higher bid comes in.
However, there’s likely a limit on how much you can afford to pay for a home. So, it’s also important to include a ceiling that prevents you from bidding more than you’re able to pay. In the example, your ceiling price is $270,000. So if another prospective buyer puts forward a best offer of $275,000 for the home, you’re officially out of the bidding.
An escalation clause can be useful anytime you’re house hunting in a seller’s market, where the number of buyers exceeds the number of available homes and any available real estate is in high demand.
How To Put An Escalation Clause In Your Home Offer
Before adding an escalation clause, you should always seek advice from a real estate agent or real estate attorney. REALTORS® and real estate lawyers can help you determine whether an escalation clause is appropriate for your situation.
If you decide to move forward with an escalation clause, you’ll want to include:
- The escalation amount: Your escalation clause should outline the amount by which you’re willing to exceed any other offers. For instance, if your escalation amount is $5,000 and another buyer offers $260,000 on a house, your new offer is $265,000.
- A ceiling: A ceiling is the maximum amount that you’re willing to pay to purchase that home.
- Proof of an offer: For the escalation clause to go into effect, the seller must provide proof that a competing offer exists. That way, the seller can’t use your escalation clause as an excuse to make you pay more for the home.
Escalation Clauses And Price Ceilings
When you’re adding an escalation clause to your offer, it can be hard to know what the price ceiling should be. Two major factors can help you determine the ceiling: your real estate agent and a mortgage preapproval letter.
Your Real Estate Agent
Your real estate agent should have a sense of what the home is worth and how the current mark could affect the home value. That’s why it’s important to work with a real estate agent you trust.
If necessary, you can pay more than the asking price for the property, but you should always do so with caution. Choosing a ceiling significantly higher than the home’s value may not be worth it in the long run.
Your Preapproval Letter
A preapproval letter is a document from your mortgage lender stating how much you’ve been approved to borrow. The ceiling on your escalation clause shouldn’t exceed the amount you’ve been approved for.
Risks That Accompany Escalation Clauses
In a competitive real estate market, an escalation clause can be helpful, but certain downsides also exist. For one, you’re laying your cards on the table right from the beginning by letting the seller know the maximum amount that you’re willing to pay for the home. So, nothing is stopping the seller from presenting you with a counteroffer at your ceiling price.
Or if the seller comes back to you with a counteroffer from another buyer, you don’t know if it’s a bona fide offer. It’s possible the seller asked a friend to submit an offer to drive up the price of the home.
And some sellers don’t like escalation clauses because an escalation clause can prevent them from accepting counteroffers from other interested buyers.
For other sellers, the final sale price isn’t always the main concern. For instance, they may prioritize a speedy closing or not having to do any repairs on the home. So, an escalation clause isn’t a guarantee that your final offer will be accepted.
Can You Back Out Of An Escalator Clause?
One of the trickiest parts of adding an escalation clause is that it can be hard for you to change your mind and back out of the real estate contract if your offer is accepted. After all, the seller turned down other competing offers on the condition that you would buy the home.
Whether you’re able to back out of an escalation clause depends on the extenuating circumstances and the details of your contract. For instance, if certain contingencies in your contract weren’t met, you may have a case for backing out of the agreement.
Above all else, it’s important to consult with a real estate attorney, who can help you understand your options and figure out your next steps.
Tips For Success With Using Escalation Clauses
If you decide to move forward with an escalation clause, you’ll want to go about it in the right way. Up next are some tips to help you be more successful when you’re putting your home offer together.
When you’re adding an escalation clause to a real estate offer, you’ll want to show the seller that you’re serious about buying the property. However, it’s important to be realistic about what you can afford.
Pick a price ceiling that’s realistic based on your mortgage preapproval letter and your financial situation. Keep in mind that no matter how appealing your offer seems, it could still lose out to another bidder.
Save The Clause For A Property You Love
If you’ve previously found a home you wanted to purchase and someone else placed a winning bid, you know how frustrating that can be. So, it might be tempting to use an escalation clause on every home offer you make. However, this isn’t always a good idea. It’s better to use an escalation clause sparingly and only for a home you love and can’t imagine losing to another buyer.
Consider Adding An Appraisal Contingency
If you decide to include an escalation clause on your offer, you might consider adding an appraisal contingency as well. An appraisal contingency states that once the home is appraised, it must meet the purchase price on which you and the seller have agreed. This will help you avoid paying more than the market value for the property.
The Bottom Line On Escalation Clauses
When you find your dream home and are ready to make an offer, an escalation clause can be a good way to protect yourself in a competitive market. It helps ensure that your bid is higher than any competing bids on that home, up to a point.
However, an escalation clause doesn’t guarantee the seller will accept your offer. Some sellers will want to consider competing offers, and others may not like escalation clauses in general.
If you’re just starting the home-buying process, fill out your application today. We’ll help you determine how much you can afford to pay for your dream home.