Escalation Clauses: Bad or Good?

Escalation Clauses: Bad or Good?

Many people in Arizona are aware that there are multiple offers on homes under $200k that are currently owned by a bank. Consider this question I was asked at least once this week:

Question: My Realtor tells me that if I am tired of being outbid on homes, I might want to consider using an “escalation” clause in the contract. What do you think?

My Answer: There is a fine line between brilliance and stupidity and in my opinion, the escalation clause in today’s Phoenix housing market falls exactly on that line.

Really?

First let’s paint an escalation clause in a brilliant light. Let’s say that you are a 1st time home buyer who plans to finance your new home with an FHA loan. This means that your offer is most likely going to be up against at least one other all-cash offer and one thing you can do to “win” the bid is to simply bid a little more than the other guys. An escalation clause in your offer will do that for you. And there is really only one way that it can work… Using an escalation clause like this will only be considered brilliant if you also make the property value subject to appraisal. In other words, if after the escalation clause your offer ends up being $100,000 and the property only appraises for $90,000 then if you have a “subject to appraisal” clause in there the lender will have to decide to drop the sales price to $90,000 or put it back on the market. Where this can work (and I have seen it work) is the lender will choose your offer above all other cash offers because it is the highest ($100k) – only to have to lower their sales price because of the “subject to appraisal” clause to $90k.

Now let’s paint it in the stupidity light. If you do use an escalation clause but don’t include a “subject to appraisal” clause, then you are really setting yourself up for financial pain. You could easily end up paying more than the property is worth – in cash – because you won’t be able to finance it into the loan. That is the worst possible scenario. Another possible “bad” scenario that could happen is that you could put the escalation clause in, put the subject to appraisal clause in — only to have the lender refuse to lower the sales price and ends up putting it back on the market. Even though you haven’t lost any money per se — you have lost time and effort.

Are escalation clauses bad or good? It depends. And a lot of what it depends on is luck. Luck as in it depends on decisions that the lender who owns the home makes.