In a real estate contract initiated by a potential buyer of a house, an escalation clause is either an addendum to the contract or built into the original contract. It is a clause that says that potential Buyer A will pay a certain amount for a house, but if another buyer, Buyer B, comes along and offers a higher price, Buyer A will pay a certain dollar amount more than Buyer B. There are many other details that can be built into an escalation clause too, and there are also some potential ramifications.
Consider working with a financial advisor on your long-term financial plan as you buy or sell real estate.
How Does an Escalation Clause Work?
An escalation clause, sometimes referred to as an escalator, is used most often for an exceptionally desirable property that’s likely to draw more than one competitive bid. It’s also used in hot real estate markets when the inventory of houses for sale is low, and conditions are right, such as low mortgage rates, for potential buyers.
An escalation clause is typically comprised of a trio of things. The first part is the initial offer for the house, which represents the base level being set. The second part, called the escalation amount, demonstrates how much the buyer will surpass other offers by. Rounding out an escalation clause is the designated maximum amount the buyer will pay for the house, regardless of the aforementioned escalation amount.
Some sellers won’t accept a real estate contract to buy a house if it contains an escalation clause. Other sellers like escalation clauses because buyers try to outbid each other and may drive up the selling price of houses, which happened in our example. Escalation clauses tend to weaken the position of buyers since the seller, and other buyers, are fully aware of the maximum the buyer will pay for the house. Including an escalation clause in a real estate contract takes away most of the negotiating power of the buyer.
Example of an Escalation Clause
Let’s say a seller has their house on the market for $200,000. They anticipate they’ll sell it quickly since market conditions are right. Buyer A has their realtor write up an offer for $200,000 since they think it will sell for at least the asking price. However, there is an escalation clause in Buyer A’s real estate contract that authorizes the realtor to offer $2,000 above other buyers’ offers, up to a maximum of $10,000.
Then, along comes Buyer B. This buyer thinks the property will sell at a premium and offers $205,000. There is also an escalation clause in Buyer B’s offer that authorizes offers of $3,000 above other buyers’ offers, up to a $12,000 cap.
Escalation clauses are disclosed to the seller, so they are aware of the positions of both borrowers. Buyer A escalates the offer to $207,000 and Buyer B responds by escalating the offer to $210,000. Since Buyer B is now at the maximum escalation amount for Buyer A, Buyer B’s offer is likely accepted for $210,000.
Pros and Cons of Escalation Clauses
While there may appear to be only positives when it comes to an escalation clause, there are also somethings you’ll want to be mindful of as a buyer. For instance, the buyer loses a lot of bargaining power if their offer has an escalation clause. The seller will already know the maximum the buyer is willing to pay for the house. In addition, sellers may reject offers with escalation clauses because they cannot make counteroffers to other buyers if they allow an offer with an escalation clause.
Some buyers may also find that there’s a conflict between the use of an escalation clause and the appraisal of the house. Lenders seldom loan more to buyers than the appraised value of the house, so that could lead to problems in funding down the road.
Again, there are also many benefits to using an escalation clause as a prospective homebuyer. For example, an escalation clause is an indication to the seller that you’re very serious about buying. If your bid is identical to another bid, the seller might consider that extra vigor when deciding which bid to accept.
Including an escalation clause in your offer ensures you’ll stay within your budget when buying a house. This will help you avoid, in the heat of the moment, overbidding on the price while ignoring your budget.
An escalation clause is used in a real estate contract in hot housing markets where buyers are engaging in bidding wars to try to secure homes. An escalation clause may not always be a good thing for the buyer. As you consider making an offer on a property, it’s important to work with a realtor who knows all the intricacies of the use of escalation clauses and can properly advise you whether to include one in your offer.
Tips on Home Buying
- Before buying a home, you may want to speak to a financial advisor for help determining what you can afford given your financial resources. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Closing costs are a significant expense when buying a home. SmartAsset’s closing cost calculator can assist you in determining how much in closing costs you are going to have to pay.
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