What is a letter of explanation?
Underwriters are kind of like detectives: They’ll investigate anything in your financial history that looks out of the ordinary to try and get to the truth. If you’re applying for a mortgage, you can expect underwriting teams to scrutinize your finances, credit reports and employment records. That’s why it’s so important to get all of your monetary ducks in a row before heading out to buy a new house or refinance a mortgage.
But that doesn’t necessarily mean that any red flags in your loan application will sink your prospects of securing a mortgage or a good interest rate. You’ll likely have an opportunity to tell your side of the story and clarify any potential concerns with your financial situation.
A letter of explanation can be a great way to ease any concerns about your loan qualifications or creditworthiness. Underwriters may request such documents if they want more details about your finances, debt obligations or work history. Not everyone’s a born wordsmith, however, which is why we’ve put together this guide to help you both understand explanation letters and learn how to write a letter of explanation for mortgage lenders.
What is an explanation letter?
When you apply for a mortgage, your lender’s underwriting team will pore over your financial history to look for any potential red flags in your loan qualifications. First and foremost, underwriters want to know if you have the cash flow to stay on top of your mortgage payments and repay your loan balance. They’ll also check that you have a strong track record of paying down debt and managing your finances.
But if underwriters find potential causes for concern in a loan application, they may ask homebuyers to write an explanation letter.
Explanation letter meaning
A letter of explanation — sometimes abbreviated as either LOX or LOE — is a written document that supplements your financial records and directly addresses potential concerns regarding your loan qualifications. Explanation letters provide details and context that underwriters would otherwise not be able to glean themselves. In particular, underwriters will request a letter of explanation when they spot issues like derogatory credit, large deposit, cash flow problems and gaps in employment.
The borrower — that means you — will be responsible for writing the letter of explanation. Your real estate attorney, loan officer or real estate agent may offer some guidance on what information to include, but at the end of the day, you’re going to need to sit down and draft the letter yourself. After all, no one knows your past better than you.
Why do underwriters ask for letters of explanation?
Mortgage loan processes rarely provide much context for underwriters to consider beyond the financial documents that are submitted. Underwriting specialists may see a gap in your employment history, for instance, but they probably won’t know if you paused your career to stay home with your children or take care of an ailing relative. Filling in the details can be helpful for both lenders and borrowers, which is where an explanation letter can come into play.
When do underwriters ask for explanation letters?
Underwriters may request a letter of explanation for a number of scenarios, ranging from relatively minor incidents to extreme financial distress. Here are some of the most common reasons underwriters will ask to see an explanation letter:
Reasons you might need an explanation letter
- There have been several inquiries on your credit report in recent months.
- There are irregularities in your credit report like multiple names, addresses and contact information.
- You have long gaps in your employment history.
- You have made numerous late payments on credit card bills, rent, auto loans and other recurring debt.
- You have derogatory credit, such as a credit score that may give lenders pause.
- You have overdrafted your accounts on several occasions.
- Your income and cash flow have dropped significantly.
- You have declared bankruptcy at some point.
- There are large, unexplained deposits listed on your bank statements.
These conditions could indicate that you’re a risky borrower. But there just as easily could be fairly benign — or at least perfectly understandable — reasons for many of these red flags:
- Your relatives could give you a large deposit of money as a gift.
- You may have neglected to pay your bills because you were distracted by other distressing events going on in your life — chronic illness, mental health issues or the loss of a loved one, for instance.
- You decided to buy a house and a car at the same time, shopping around for the best financing terms on both — which means multiple credit inquiries within a short window.
- You took a sabbatical to pursue a passion project, launch a new business venture or go back to school.
Lenders can be pretty sympathetic about extenuating circumstances that negatively impact your finances. So, don’t feel stressed out if you’re asked to present an explanation letter. Your mortgage company just wants to get the full story behind your financial history. There’s no reason this kind of request needs to derail your plans to buy a home.
Are there any drawbacks to writing a letter of explanation?
As long as you’ve acted in good faith, you shouldn’t worry too much about the fallout from writing an explanatory letter. If you can give a compelling reason for your actions, even the most seemingly damaging financial misstep could be rationalized. The only times a letter of explanation could blowback on a borrower would be if you provided false information in your account, admitted to illicit activity or simply lacked a compelling reason for your actions.
Having said that, don’t submit an explanatory letter unless your lender asks for one. Writing an unsolicited letter of explanation could just draw attention to qualification concerns that the underwriting team wasn’t too concerned about to begin with.
5 types of explanation letters to know
As we highlighted above, there are plenty of scenarios that may raise red flags with your mortgage provider. The type of explanation letter you write really depends on the specific situation you’re trying to address. These are the most common letters of explanation you may be asked to write:
- Letter of explanation for credit inquiries: Write a credit inquiry letter if you’ve experienced multiple credit checks in a short timespan — say, a few months.
- Letter of explanation for derogatory credit: Use a credit explanation letter if you need to address issues that come up during a credit check — late payments, unpaid bills and collection notices, for instance.
- Letter of explanation for address: Take this approach if your credit report pulls up multiple addresses under your name. Those could include vacation homes, investment properties or previous residences.
- Bankruptcy explanation letter: Bankruptcy is about as serious a financial setback as you can experience. Write a letter of explanation to describe the circumstances surrounding your bankruptcy and your decision-making during that difficult time.
- Unemployment letter of explanation: A long period of unemployment could suggest that a borrower has trouble holding down a steady job. And that, in turn, could make it difficult to stay on top of monthly mortgage payments. Writing a letter of explanation may help ease any concerns about your work history. For instance, you could have been self-employed during that stretch.
Mortgage letter of explanation template
Writing a letter of explanation can be daunting, especially for first-time homebuyers. When it comes time to put pen to paper, your mind may draw a blank, even if you have a perfectly good reason for any issues that come up with your loan application. You don’t need to reinvent the wheel here. Following a letter of explanation template will help ensure you provide the right information and present your case in a way that’s easy for underwriters to scan and digest. Feel free to use this explanation letter sample as a guide:
Explanation letter template
Your contact info (name, address, phone number, email)
Your loan application info (lender’s name, application number, loan officer’s name)
Your greeting, ideally addressed to a specific person but “To whom it may concern” can work in a pinch)
Paragraph #1: Acknowledge the underwriter’s request for an explanation letter and the specific issue at hand
Paragraph #2: Explain the circumstances surrounding that issue. Be brief and try to stick to the facts.
Paragraph #3: If applicable, provide more context as far as how you have addressed that issue and how your financial situation has changed for the better.
Paragraph #4: Note any additional documentation that you’ve included with your letter: bank statements, receipts, copies of bills, etc.
Closing: Thank the recipient for their assistance and offer to provide more information or documentation if need be.
Sign-off with your name: Keep things relatively formal and polite when signing your letter. “Sincerely,” “best” and “regards” are all fine closings.
How to write an explanation letter for mortgages
Hopefully, our example of an explanation letter gives you plenty of concrete steps to take if your lender requests this extra step in the mortgage process. That being said, here are a few more tips to follow when writing a letter of explanation:
- Keep it short: Underwriters just want a quick explanation, so channel your inner Hemingway and write as briefly as possible.
- Stick to the facts: The purpose of an explanation letter is to provide context, but there is such a thing as too much information, especially if your description of events veers into subjective territory. Providing extraneous details could just open the door to even more questions about your finances or credit history.
- Be professional: People have a tendency to respond emotionally to questions about personal finances, but you should do your best to maintain an objective, professional and polite tone throughout your letter of explanation.
- Document if possible: Your letter will be a lot more compelling if you have evidence to back up your claims. Don’t hesitate to pass along materials that strengthen your case.
- Stay calm: It isn’t the end of the world if your lender asks for an explanation letter. Remember: They’re still considering your loan application, so that’s good news. Also, the letter could be used to figure out what loan terms you qualify for, such as your mortgage rate. It doesn’t necessarily determine whether or not you qualify for a home loan at all.
- Review and proofread: Go over your letter to check for spelling errors, confusing sentences or anything that might detract from your explanation. And once that’s done, read through it again to double-check everything is factual and professionally written.
Mortgage lenders — underwriters, more specifically — may request a letter of explanation if they find potential red flags in your loan application. Common issues can include unpaid bills, loss of income and unusual bank deposits.
An explanation letter isn’t necessarily a huge cause for concern, however. If your financial situation has improved since the incident in question or there are extenuating circumstances to consider, a letter of explanation can help clear the air.
A good lender will work with you to review your finances and find a type of home loan that fits your circumstances and needs. So, don’t fret if an explanation letter comes up during your loan application. Sit down with your mortgage specialist to figure out exactly what information to include so you can move past this bump in the road and secure a home loan.
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