Buying and moving into a new home is one of life’s great experiences, especially if you’re buying your first home. From getting that pre-approval to the “yes!” response on an offer to closing and moving in, every step is exciting. And while the process is engaging and fun, it’s important to prepare for moving day […]
What you need to know about an escalation clause
There’s not much question about it; today’s real estate market is a seller’s market.
It’s a simple matter of supply and demand. Econ 101 students all learn about supply and demand, and one nearly unwavering aspect of supply and demand is that when supply drops and demand for the remaining goods and/or services remains constant, their price will rise.
The current housing market is experiencing its lowest level of supply since 1999. While the number of prospective buyers remains high, the supply of homes on the market continues to lag.
This means competition for available homes is strong, which means buyers recognize they have to be aggressive and willing to outbid competing buyers if they want to purchase a home.
Enter the escalation clause.
No one wants to make an offer on a home only to learn another buyer submitted a higher offer and ended up buying the home. Certainly, buyers can submit offers above, or even substantially above the seller’s asking price, but that is no guarantee of success. So many buyers include an escalation clause in their contract offer.
Simply put, an escalation clause is authorization by a buyer to increase their offer up to a specified upper limit. For example, Buyer A may submit an offer of $300,000 on a home, with an escalation clause authorizing an increase in the offer up to $325,000. Buyer B submits an offer of $310,000. Though Buyer B’s offer is higher than Buyer A’s, Buyer A’s escalation clause automatically increases their offer to beat that of Buyer B.
Sounds good, right?
Maybe. But like everything in real estate, it’s smart to look at the complete picture. Here are six things you should know about escalation clauses:
Be aware of the home’s appraised value
While an escalation clause may seem like an excellent way to outbid a client, buyer’s need to remember if their original offer is at the edge of their envelope for their amount to be financed, a sudden bump to their higher offer, combined with miscellaneous additional expenses can max out their offer, or force them to increase their down payment.
An escalation clause can cause a bidding war
While you may think the escalation clause you added to your contracted offer is a “just in case” safeguard, and therefore unlikely to end up being exercised, the opposite often ends up being the case. While sellers are required to provide proof of a bona fide higher competing offer, in today’s seller’s market that is often not a challenge. Multiple offers on the same home can end up being a battle of the escalation clauses.
Even without a competing offer the seller may ask you to increase your offer to the maximum amount in your escalation clause
While a seller cannot demand you commit to the maximum amount in your escalation clause, there’s no way for you to know if the buyer has several “hot prospects” who are ready to make offers on the home you want to buy. Again, the seller can’t demand your top offer, but the seller can ask, and you may feel compelled to agree.
An escalation clause can “tip your hand” for the seller
Think about it, the maximum price you include tells the buyer how high you’re willing to go to purchase the home. This gives the seller a valuable bit of information and increased leverage in negotiations.
An escalation clause can cause a seller to rethink the listed price of the property
For example, you’ve listed your home for $300,000 and – as is so often the case in this seller’s market – you get an offer the first or second day your home is on the market. That offer includes an escalation clause of up to $390,000. You are almost certainly going to rethink your pricing. That may be good news for sellers, but it’s nothing a buyer wants to have happen.
An escalation clause can have several positives
First, an escalation clause can show a seller that you’re a serious buyer and that your financing is rock solid. Second, if your escalation clause includes a high enough top price, it can end competition. Finally, including a significant number in your escalation clause can do much to help you secure the dream home you’ve always wanted.
The bottom line on escalation clauses is that while they have pros, there is good reason to think carefully about incorporating one into your contract offer.
Chances are good you don’t buy homes on a regular basis. But your realtor and your lender are deeply involved with real estate transactions every day. As your lender knows everything about your financing and your financial position, it’s important to work closely with your lender to make decisions on several issues, including whether to use an escalation clause and if so, deciding on its upper limit.
The loan officers at SmartMortgage have experience in supporting countless buyers from application to closing and are ready to help you. Contact us today and get the professional advice and service you need