What to Do When a Lender Requests a Letter of Explanation

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Updated on Friday, January 18, 2019

During the mortgage loan application process, a letter of explanation may be requested. The lender may ask a borrower to provide this letter if something on the credit report needs explaining, such as an increase in debt or a missed payment. Such financial stresses could be caused, for example, by a recent job loss that suddenly reduced income, but that’s not apparent to a lender without further explanation.

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Sure, this letter may seem intimidating if you have to explain your past financial mistakes or struggles to a lender, but being asked for one shouldn’t be feared. The letter can help enhance your home loan application by allowing the lender to get to know you better so that you come across as an honest and reliable applicant.

What is a letter of explanation?

Now that you know a letter of explanation shouldn’t be considered scary, let’s discuss what exactly it is and how it comes into play. When something on your credit report may need more clarification, such as a late payment or a bankruptcy filing, a lender may request more information by having you write a letter. In this letter, you have the opportunity to explain any financial problems you’ve had in the past. If you present your situation correctly and honestly, you can show the lender that you are responsible with your money and will be able to financially commit to a mortgage.

Each lender takes a risk when approving a borrower for a new mortgage. This means that in order for your mortgage loan to be approved, certain underwriting requirements must be met, including investigating a borrower’s financial background. All Federal Housing Administration (FHA) mortgages need to follow the guidelines of the U.S. Department of Housing and Urban Development (HUD). These requirements include looking into the borrower’s “collections and judgments” history, which could affect creditworthiness and ability to make on-time mortgage payments.

By writing a letter of explanation, you can present the reasons behind any negative marks on your credit history by supplying the facts — what happened and why — while also offering specific documentation to help explain the situation in more detail. Describing in your letter how you went about fixing your past financial issues can also show the lender you are able to handle your mortgage now by learning from financial errors in the past.

Why might a lender request a letter of explanation?

In the general sense, a lender might request a letter of explanation simply to gather more information to clarify and determine a borrower’s eligibility. However, there are many specific reasons why a lender may request such a letter from a borrower. Let’s take a look at some of the most common reasons behind a letter request.

  • Address change or discrepancies

An incorrect address or one that has recently changed may require more details outlining a recent move or perhaps a change in living situation due to a divorce.

  • Job change

A change in job or recent unemployment can have a negative impact on your finances (for example, not being able to keep up with monthly credit card payments) and may need to be discussed. If this is the case, you’ll likely also need to provide proper documentation, which can include anything from your tax returns to a job termination letter.

  • Income change

It’s important to show lenders that you can make your monthly mortgage payments with reliable income. If there was a decrease in income when you left a company to start your own, for example, you may need to explain this, along with the steps you took to pay your debts since that time.

  • Large deposit into bank account

If you recently made a large deposit in your bank account, especially one with an unidentified source, a lender may need clarification, which can include a letter of explanation and physical verification of this transaction. For example, if a relative gave you a few thousand dollars for your birthday last year, you may need to show receipt of the check and/or the deposit slip.

  • Late payments

Lenders want to know you will make your monthly mortgage payments on time, so if you have had late payments in the past, it can be cause for alarm. If this is the case, you may be asked to clarify why you missed a payment, giving reasons such as a job loss, which led to less income.

  • Other circumstances

There are other conditions that may require a lender to ask for a letter of explanation. For example, if a borrower has a lot of overdraft fees from the bank or has taken out hefty withdrawals on a recurring basis. Student loan delinquency, identity theft and self-employment income that has fluctuated significantly from one year to the next can also cause lenders to want to know more. In short, any circumstance that makes a borrower appear risky, including past financial trouble, can cause a lender to be on the alert and need more information.

How to write a letter of explanation

If a lender requests a letter of explanation, don’t worry. These letters are pretty standard when you are applying for a mortgage, and your loan officer can offer assistance with composing one if needed. It’s just up to you, the borrower, to ensure all information is accurate. But if you’re nervous about writing a letter of explanation, there’s an easy format you can use to guide you.

Here are the most important things your letter of explanation should have to help explain your individual situation:

  • Facts – Be sure to include all the facts behind any negative credit history with proper dates, numbers and any other evidence that will help support your situation.
  • Documentation – Provide all correct documentation to help back up your statements, including anything from past tax forms to medical bills.
  • Resolution – Explain how you worked to resolve any financial issues in the past, such as paying down debt or working with a financial planner to better manage your money so these issues won’t occur again.
  • Acknowledge your mistakes – Recognize you made mistakes in the past with money, without ever blaming creditors for these issues.
  • Short and simple – Keep the letter brief and to the point so it is clear to the lender you have a firm understanding of what occurred and how you fixed it.
  • Proofread – Read through your letter, or ask someone else to, to triple check that both spelling and grammar are correct.
  • Your details – Remember to provide your name, contact information and signature on your letter.

Conclusion

If a lender requests a letter of explanation, don’t panic. Remember that these types of requests are normal when applying for a mortgage. A lender wants to get to know you as a borrower to better understand your financial history and ensure you can pay for your new mortgage loan. A letter of explanation should not be feared. Use it to help explain your past financial situations, what you have learned from them and how you plan to keep these circumstances from ever happening again. By taking simple steps to write this letter, you can ensure it is accurate, clear and concise.

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