When you apply for a home loan, the mortgage lender collects a wide variety of different paperwork to establish proof of income, employment history, credit scores, and much more. Once the paperwork is collected, your information goes into underwriting, where the mortgage company evaluates the information and determines whether or not you qualify for the loan.
However, sometimes the information doesn’t offer a clear enough picture. When the picture is unclear for a mortgage underwriter, they may require clarification. A mortgage Letter of Explanation provides that clarification.
Here we explain the Letter of Explanation and give tips on how to ensure what you write is what they are looking for.
- A Letter of Explanation is a brief document that provides clarity for the underwriter during the loan process. When a Letter of Explanation is requested, don’t assume you will be denied the loan. Oftentimes, providing the information gives them the clarity they need for approval.
- In many cases, you may already know circumstances that will require a Letter of Explanation before you even turn in paperwork, such as explaining gaps in employment.
- A Letter of Explanation does not need to be a long, in-depth story. In fact, the best advice is to keep your letter informative, yet short and simple.
What is a Letter of Explanation in a mortgage?
A Letter of Explanation is a brief document written and provided by the borrower that offers clarity to certain information provided during the loan process, such as credit history. For example, your work history may show a gap in employment that lasted a couple of months. In this case, a Letter of Explanation could state that you were laid off during the COVID lockdown and unable to work at no fault of your own.
Following that same example, the underwriter may find that during that same period, you experienced an increase in late payments and overdrafts during that same period. In this case, a single Letter of Explanation can state that the long-term lack of employment due to COVID lockdowns decreased your income, and once your reserve funds depleted, some payments were paid late or once you got back to work. You could also now show that your reserve funds have been replaced and you have been back on track since that timeframe.
Importance of the letter in the mortgage application process
Letters of Explanation as we show above are general requirements from the secondary agencies that purchase or back specific loans, such as Freddie Mac, Fannie Mae, the Federal Housing Administration, and the Department of Veterans Affairs. They require these letters when the information provided by the borrower is unclear. These letters provide a bigger picture of the borrowers’ history and show that the underwriters made their decision based on all the available information. Without this information being provided, the underwriter is likely to deny the loan.
How to write a Letter of ExplanationWhen writing a Letter of Explanation, there are key elements that you want to make sure are included. These can include:
- Facts: Be sure to include all the specific facts that support your situation at the time. For example, in the example above, you would want to include the exact date you were laid off and when you returned to work. You want to show your starting reserve funds balance and how you used those funds to pay debts during that time and when they ran out and you fell behind.
- How did you resolve the situation: In this same example, you would include the date when you returned to work, when you caught up with debt obligations, and how you have worked to build your reserve funds since restoring employment.
- Acknowledgment: When writing a Letter of Explanation, you want to submit the facts, show the resolution, and explain how you plan to prevent this issue from happening in the future. In this case, building a larger reserve fund and cutting back your existing debt, for example.
Tips for writing a good Letter of Explanation
When writing your Letter of Explanation, you want to keep it simple, short, and informative. At the same time, however, you want to make sure you include all the necessary information your underwriter will need to develop a clearer understanding of your situation. Every Letter of Explanation should include:
- The name of your lender and their complete address and phone number
- The date the letter was written
- A subject line including your name and application number
- One or more paragraphs that provide the underwriter with the requested information
- A simple and polite closing
- Your full legal name, both signed and printed
- Your full mailing address and telephone number
- If you are attaching any supporting documents, be sure to explain that they are attached to the letter and the information they show.
Letter of Explanation Template
[Lender’s name, complete mailing address, and phone number]
Re: Name and application number
Dear Mr. or Ms. [name of the person requesting the letter of explanation],
Here is an explanation of all the items you requested.
The gap in Employment from March 15, 2020, to July 2020
As a non-essential worker during the initial lockdown of the COVID pandemic, I was temporarily laid off from my position until my company could transition to a work-from-home platform that went into effect in July 2020.
Late payment to Wells Fargo (car loan) dated July 2020
I was laid off from my job in March and unable to make my $550 car payment in July because my savings were depleted. I went back to work in July and recovered quickly. At that time, I made up the back payment and its associated late fees while also beginning to restore my savings.
As you can see from my current statement, my account with Wells Fargo is currently current and in good standing at this time, and all payments are being made on time. I fully understand the seriousness of taking on a mortgage, and as you can see before the pandemic, I take making payments on time very seriously and have now worked to build up a more robust savings account to ensure obligations are taken care of in an emergency situation.
[Your printed name]
[Your current street address, including city, state, and zip code
Do you need to provide a Letter of Explanation?
While an underwriter may request a Letter of Explanation for many different reasons, these are some of the most common reasons they may require additional information.
Recent job change or gap in employment
Steady employment, including a 2-year work history, is required by most lenders in order to show that you receive a steady income that allows you to pay your obligations on time. If you have significant gaps in employment at some time during the last two years that lasted longer than 30 to 60 days, your underwriter may require an explanation, such as in our example above.
Credit issues or derogatory marks on a credit report
Negative items on your credit can be immediate red flags for an underwriter. They can show that you are unable to pay bills on a regular schedule or have defaulted on loans previously. An underwriter may request a letter that explains these negative marks and why they are there.
Change in income or significant decrease in income
When income is constantly fluctuating, it may be a sign that you will not have a regular source of income that you can depend on when considering loan obligations. An underwriter will want to understand why income may have gone up or down over the last 2-year period. Reasons behind these changes could include anything from promotions to going through a divorce, working less to attend continuing education, or changing over to self-employment.
Large deposits or withdrawals from a bank account
Large deposits or withdrawals outside of normal behavior are red flags for underwriters. For example, a $10K random deposit on your bank statement will require an explanation. In this case, for example, grandpa passed away and left all the grandkids $10K.
Underwriters often look to rental history when determining how much mortgage payment a borrower can afford. If you haven’t been paying rent and living with your parents, for example, you do not have a history of rental payments. In this case, you would need a Letter of Explanation from your parents stating that you have been living rent-free for a specific time frame.
With ID theft on the rise, applying for a mortgage with an address that does not match those are your credit report automatically sends up red flags. If you have recently moved or are staying temporarily with friends or family while your house hunt, you will need to provide clarification as to why your current address does not match.
Are you applying for a new mortgage as newlyweds? Do you have credit established under your married name? If your name recently changed due to marriage or divorce, you may need to provide information about this change that includes copies of a marriage license or divorce papers.
Frequently asked questions
When it comes to Letters of Explanation, borrowers often have many questions. Here we answer some of the most frequent questions asked.
Is a Letter of Explanation a bad thing?
No, a Letter of Explanation is not always a bad thing and you should never assume that you will be denied if an underwriter requests one. In most cases, it is simply the underwriter requesting more information in order to make a determination.
What if my Letter of Explanation is rejected?
If your Letter of Explanation is rejected by the underwriter, you may try to provide an additional letter that offers additional information as well as documentation to support your information. If this is still rejected, you may want to switch to another lender or a more flexible loan program, such as an FHA or VA loan.
Are there documents I need to include with my letter?
Documents are often required to provide proof of a particular situation. For example, if you are recently married or divorced and received a Letter of Explanation regarding the use of a different name, you will need to provide a copy of your marriage license or divorce papers. Other financial documents can include bank statements, tax returns, real estate income, and creditor statements that show you have addressed missed payments.
When a Letter of Explanation may be necessary
If you receive a Letter of Explanation request from your lender during the loan application process, there is no reason to get worried. Simply provide the additional information and clarification requested in a short and simple manner. Do not assume the worst, and just be honest with the lender.
Navigating the Home-Buying Process
Navigating the home-buying process can be overwhelming and frustrating. Receiving a request for more information, such as a Letter of Explanation, rattles the nerves of every home buyer. The team at Hero Home Programs understands the loan process and can help you navigate through every step, including the creation of this additional information requested. Our goal is to help borrowers achieve home ownership while also receiving the best loan options available.
To learn more about how we can help you get the keys to your dream home, schedule a consultation today.