The Benefits and Drawbacks of Escalation Clauses
If you’re in a competitive market and think you’ll be going up against multiple offers for your dream home, an escalation clause may give you the advantage you need.
An escalation clause is a provision in a purchase offer or homebuying agreement that allows a potential homebuyer to increase their bid automatically if a competing offer comes in higher. It’s an excellent way to show how serious you are, but it also comes at a price.
Let’s explore how escalation clauses work, their pros and cons, and how to include one in your offer, with or without a realtor.
How Escalation Clauses Work
An escalation addendum or clause usually has three main components:
- Your original offer outlined in the purchase agreement
- The increments in which you will outbid a higher competing offer
- The maximum amount you’ll pay for the home (a.k.a. your price cap)
In an escalation clause, your offer will automatically increase incrementally whenever there’s a higher offer price. Given that 48% of homes for sale in 2022 received three or more offers, escalation clauses are becoming more popular.
This can get a little confusing, so here’s an example of how an escalation clause works:
Let’s say Amy finds a fantastic home with an asking price of $700,000. It’s a seller’s market, and the house is a steal at that price, so it’s likely to strike a bidding war between multiple potential buyers. However, the housing market is always an adventure, and there’s no way of knowing for sure.
Amy decides to have her initial offer match the home seller’s list price of $700,000 but also includes an escalation clause. She agrees to an escalation amount of $5,000 any time another prospective buyer’s offer comes in higher, and she lists maximum purchase price at $750,000.
Now you can see the three components of an escalation addendum at work:
- Amy’s original offer: $700,000
- Incremental increase rate: $5,000
- Amy’s highest offer: $750,000
If the seller accepts this, then the escalation clause is in effect! If someone offers the seller $700,001, Amy’s amended offer automatically becomes $705,000.
If another buyer offers $715,000, Amy’s new offer is $720,000. This process continues until the seller accepts the best offer (which is often also the highest offer) or until another potential buyer surpasses Amy’s highest offer, in which case she’s out of the running.
When Should You Use an Escalation Clause?
Escalation clauses are often advantageous in a seller’s market. These clauses help distinguish your offer when homes are selling quickly and indicate to sellers that you’re serious about buying their home. Not only are you putting an offer in, but you’re also stating that you’re willing to automatically counter the highest bid with a better offer, as long as it’s at or below your price cap.
However, escalation clauses also have downsides, so they’re not always best suited for your situation.
The Pros and Cons of Escalation Clauses
As with almost everything else real estate-related, escalation clauses have their benefits and drawbacks. Let’s start with their benefits:
Pro: Your Offer Is More Attractive
Including an escalation clause can enhance your offer’s appeal in the eyes of the seller. You’re not offering them a single purchase price for their house — you’re giving them an incremental scale of how much you will offer if someone comes in at a higher price and the maximum amount you’re willing to pay. That’s a lot more information than a typical offer discloses.
Pro: You Might Stress Less
Whether you’re a first-time homebuyer or a seasoned pro, buying a new home can be incredibly stressful. Including an escalation clause can alleviate some of the worry that buyers experience. You won’t have to come back with a counteroffer every time someone outbids you, and while someone exceeding your maximum offer can be a bummer, you at least know exactly what your final offer will be.
By outlining your escalation clause terms in advance, you can then sit back and avoid the constant stress that the news of a counteroffer can bring.
Pro: You Won’t Lose Sight of Your Budget
A bidding war can get your competitive juices flowing, and sometimes buyers will exceed their limits just to “win.” Unfortunately, this often means you’ve overpaid for the home and must now deal with the consequences.
Escalation clauses prevent this reality by ensuring that the buyer cannot pay more than their predetermined limit. If another offer exceeds it, the buyer can just walk away.
Con: Lack of Negotiation Opportunities
Once the seller accepts your escalation clause, neither the buyer nor the seller can negotiate further. The clause’s three components do all of the talking. While this may make life less stressful, you also lose some of your original bargaining power by including a price cap.
There’s also a chance that when the seller sees your maximum offer, they reject your escalation clause and ask for that amount instead.
Con: Appraisals Can Be Problematic
Mortgage lenders have specific guidelines regarding how much they will loan a buyer. This amount is typically linked to the house’s market or appraised value. An escalation clause can lead to appraisal contingency issues if your offer surpasses the home’s appraised value.
If there’s an appraisal gap, you might end up winning the bidding war only to discover that the loan you’re receiving isn’t enough to purchase the actual value of the home. If this is the case, the buyer must either pay the difference between the home’s appraised value and their purchase price, negotiate with the seller, or walk away from the deal and risk losing their earnest money deposit.
Con: You Lose Some Power
Defining your limit offer is a pro and a con. While it can alleviate some of the stress and ensure you’re not overpaying for the home, you’re also showing all your cards. This gives the seller a huge advantage because they know everything about your offer, including your maximum budget, but you don’t necessarily know where they stand.
How to Include Your Escalation Clause
The buyer and seller’s real estate agents usually help determine an escalation clause. If you opt to go the for sale by owner (FSBO) route, you’ll be responsible for handling all the paperwork involved in your real estate contract.
The required paperwork when buying or selling a house without a realtor can be a daunting task depending on where you live and the circumstances surrounding the home. Even if you do your research, there’s always the chance of you missing something.
Luckily, there’s another option: using a self-service real estate platform like Aalto.
Aalto provides you with an on-demand expert to assist with the many documents involved in a real estate transaction, including all the legal paperwork, disclosures, and items like your escalation clause. You’ll get all the help you need for just 1% of your home’s transaction fee, compared to the traditional process, which typically ends up being around 5%. If you buy a home for $1 million, that’s a $10,000 transaction fee instead of a $50,000 one. Just think of what you can do with the savings!
Are you ready to take control of your homebuying or selling process? Sign up with Aalto today!
Aalto is a real estate broker licensed by the State of California, License #02062727 and abides by Equal Housing Opportunity laws. This article has been prepared solely for information purposes only. The information herein is based on information generally available to the public and/or from sources believed to be reliable. No representation or warranty can be given with respect to the accuracy of the information. Aalto disclaims any and all liability relating to this article.