Escalation clauses: what are they, and why should you be careful with them?

Escalation clauses: what are they, and why should you be careful with them?

For many buyers, adding an escalation clause seems like the answer to a big problem: the end to endless negotiations in a bidding war. Especially in seller’s markets like the ones we’re seeing today, this clause may seem like a huge relief. But, there are several considerations before deciding to include one to ensure you’ve got your best foot forward.

What is an escalation clause?

An escalation clause is most often seen in markets where multiple offers are common.

Rather than enduring the hassle of going back and forth through a bidding war, if another offer is received on the home, this clause allows the buyers to immediately increase their offer to outbid the other party.

Escalation clauses need to be included in an original offer and should include three separate parts:

  1. Original offer price: The initial amount you offer on a home
  2. The rate of escalation: If the seller receives a higher offer, this dollar amounts states the amount by which you’ll increase your offer over theirs in order to outbid them.
  3. A cap rate: The maximum amount you’re willing to spend on the home.

For example, if you offer $500,000 for a home with a $10,000 rate of escalation up to $550,000 and the seller receives another offer of $525,000, the clause states that you’re willing to raise your offer to $535,000 to “win” the home.

Why you should be careful

If you’re thinking that this clause seems like it might make the negotiation process a little too easy, you’re right. We’d advise you to tread carefully before including one in your offer.

Here’s why you may want to think twice:

You play your full hand

The biggest strike against this clause is that it forces you to put all your cards on the table at once.

After seeing your cap, the sellers know exactly how much you’re willing to pay for the home — and they’re not under any obligation to use the clause in order to get it. There’s a good possibility that they could counter your offer, asking for your maximum amount. At that point, you’d be stuck making a much tougher choice.

In contrast, if you use a more traditional negotiation strategy, you’ll be able to play your cards a little closer to the vest. While you may know the maximum amount you’d be willing to spend on the home, the sellers don’t. They can only base their decisions off what you tell them with each bid. You may be able to pay less.

It might turn off the seller

Like it or not, some sellers get turned off by the idea of an escalation clause. You’re essentially telling them that you have the ability to spend more on the home but are trying to score a deal by cutting into their profit margin.

While some sellers may appreciate that goal, others may not and may choose to pass your offer over entirely in return. Unfortunately, it all boils down to personality, and there’s really no way to know for sure which type of seller you’re dealing with until your buying agent is able to suss out the situation.

It only considers offer price

We’ve talked before about the fact that offer price is truly only one component of an offer. When you rely on just price, you’re making that your only negotiation tactic.

Since the escalation happens automatically and the listing agent isn’t required to get in touch with you for your approval, you could be missing the full picture.

It’s possible that the winning move in your negotiation could be a change in closing date or the removal of some contingencies, but you’ll only know that for sure if you give yourself the opportunity to hear what the seller has to say.

You could have appraisal issues

Unsurprisingly, offers with escalation clauses can get expensive, and, unfortunately, that can cause problems later on.

While you may be alright with paying above market value for your home, if you’re planning on paying with a mortgage, your lender may feel differently.

Most mortgage companies agree to issue loans up to the fair market value of your home, meaning that if there’s a huge difference between that amount and the sale price, you, as the buyer, are responsible for making up the difference.

If you use an escalation clause, you need to be prepared for this. At that point, you’d have the choice of coming up with the cash or trying to renegotiate with the seller, but there’s no guarantee either of those fixes will come easily.

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