Buying a house can be a fraught process, but when the market is hot, the days between offer and closing can feel endless, especially if the mortgage underwriter asks you to write a letter of explanation.
But there’s no need to panic or assume that your mortgage application will fail. The lender is simply seeking clarification about any potential red flags in your financial documents or credit history.
What’s a Letter of Explanation?
A letter of explanation for a mortgage explains details of your financial situation that may need further clarification. Because a mortgage is a large loan, lenders need to know that the borrower is capable of shouldering the mortgage.
Lenders also know that life can’t be boiled down to a spreadsheet, and that it’s not unusual for a mortgage application to include things like a late credit payment or a period of job loss.
To do due diligence, the mortgage underwriter will ask you to explain the situation in a brief letter, which will be added to your mortgage application. Additional documentation and paperwork may be required.
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Why Do I Need to Provide a Letter of Explanation?
Common issues that could trigger a request for a letter of explanation include:
• Questions about your income if you don’t have W-2s or are self-employed
• Negative items on your credit report
• Employment gaps
• Your living situation if you don’t pay any rent or mortgage
• A property income or loss you claim
• Credit lines opened after you’ve put in your mortgage application
• Large deposits to, and sometimes withdrawals from, your bank account
Must I Explain a Large Deposit?
If there’s a big or unexplained deposit to your bank account, your lender may want to know where the money came from — and whether that money needs to be paid back.
A lender may also question any uneven income streams, or if deposits don’t line up with your W-2s or your tax returns.
If you received cash from, say, a parent to help with a down payment or closing costs, you may also need a gift letter signed by the giver and recipient stating that the money was a gift, not a loan. Your lender may have a template for a gift letter.
Keep in mind that your lender may be more likely to scrutinize any large deposits or withdrawals within the last 60 days.
Letter of Explanation Template
A letter of explanation is not an autobiography or an admission that you did anything wrong. It’s simply a statement of the reason for any discrepancy or issue, along with any documentation, to back up your current financial picture.
You can keep a letter of explanation brief. It should include:
• Your name and address
• Your lender’s name and address
• A subject line that includes your application number and name
• A brief paragraph explaining the situation
• A polite closing
• Your signed full name
It might look like this:
Lender’s Phone Number
Subject Line (RE: John Doe’s Mortgage Application)
Letter of explanation, naming the specific item being asked about and explaining it to the best of your abilities.
Applicant’s Phone Number
Enc.: (Relevant documentation).
The tone of the letter should be polite and factual. Remember: Your goal is not to pull on the lender’s heartstrings; it’s to reassure them that your application is solid and you would responsibly pay back your mortgage on time.
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4 Tips for an Effective Letter of Explanation
Although being asked to write a letter of explanation may sound like being assigned homework, it’s actually a great opportunity: It means you might be able to qualify for the mortgage you want, even with an imperfect application. Here are some tips to help ensure you get an A+ on this particularly important homework assignment.
1. Keep It Simple
When you’re asked to explain yourself, it can be easy to jump into a broad-reaching narrative starting from childhood, but the best letters of recommendation tend to be short and simple: They clarify the situation being asked about and reassure the lender that the “red flag” situation won’t affect the borrower’s ability to repay the loan.
2. Provide Clear Details
Generally speaking, you’ll want to specifically name whatever item you’re being asked about (late payments on a credit card account ending in 0101; an employment gap between 2/20/2020 and 9/07/2020; etc.).
Then explain. For instance, if you’re being asked about an employment gap, you might let the lender know that you were let go as a result of corporate downsizing and that you freelanced while searching for a new job.
If you’re being asked about late credit card payments, you might let the lender know that you were in the hospital at that time and thus unable to make your credit card payments, or whatever the case may be.
The key is to take responsibility for the issue and provide clear, pertinent details without being too wordy.
3. Be Honest
This may go without saying, but you definitely don’t want to lie in your letter of explanation. For one thing, doing so is likely to keep you from being approved for the mortgage — and for another, it can be considered mortgage fraud, a serious crime that can come with prison time and fines.
4. Acknowledge Responsibility, but Don’t Get Emotional
When writing a letter of explanation, you may be justifying negative items in your credit history that resulted from poor decisions — or just poor circumstances. Nobody’s perfect, but a lender simply wants to make sure you won’t default on your loan.
It can be helpful to acknowledge the ways you’ve adjusted your financial habits in response to a negative item. This helps to reassure the lender that it won’t have an impact on your ability to pay your mortgage.
For example, if you’re writing a letter of explanation to address late rent payments after a layoff, you might add that you’ve since saved up an emergency fund of three months of living expenses in order to avoid being financially blindsided in the future.
However, writing an emotional sob story won’t help. Remember: It’s a good idea to keep it simple, clear, honest, and as short as possible while still covering all those bases.
Getting Your Mortgage Application in Shape
Knowing what documents you need and what a mortgage lender will look at can help get your application in strong shape before you file it. Your lender will scrutinize your credit history and any late payments, especially ones within the last 12 months. But there are ways to proactively tackle any issues on your credit reports.
• Check your credit reports. Knowing what your mortgage lender may see can help you assess where any weak points may be, and what information they may ask for.
• Call the creditor if you have a recent late payment. Creditors know that accidents happen and bills may be misplaced. If your account is otherwise in good standing, it’s possible that a creditor may erase the late payment.
• Focus on additional aspects of your credit. Making sure to pay bills on time and keeping your credit utilization below 30% can help build credit.
• Think twice about opening accounts. Before and after applying for a mortgage, it can be a good idea to be mindful of opening new lines of credit or charging an extensive amount on current cards. Suddenly taking on more debt on credit cards can raise a red flag to lenders, which may result in being asked to write a letter of explanation.
Understanding how a lender will see your mortgage application can give you confidence and may help you head off any potential problems.
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A letter of explanation is when a mortgage lender needs clarity about a red flag or discrepancy that arises on your application. Knowing what to expect, having documentation ready, and answering any questions the lender may have can all be helpful in getting your home loan approved.
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