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Letter of Explanation: What, Why and How

You’re working on your mortgage application to secure a loan for your dream home. Then your loan officer tells you to write a letter of explanation about a few missed credit card payments from several years ago and your brief period of unemployment when your company downsized.

Don’t panic — this is your opportunity to show your lender that you can meet your financial obligations and that you’ve learned from any past money mistakes. In this guide, we’ll go over how to write a letter of explanation.

What is a letter of explanation?

If you have derogatory marks or gaps on your credit report, you may be asked to submit a letter of explanation to your loan underwriter that describes, clearly and concisely, the circumstances that led to those negative entries.

Letters of explanation aren’t just arbitrary mandates intended to make your mortgage application longer and more confusing. They actually contain critical details for lenders, who must follow strict underwriting requirements in order to approve home loans backed by government agencies and mortgage investors. When a lender approves you for a mortgage, they are taking a risk, and they want to know that you can handle the financial obligation.

For example, the U.S. Department of Housing and Urban Development, which oversees the Federal Housing Administration (FHA) loans often obtained by first-time homeowners, requires lenders to collect a letter of explanation for outstanding collections or judgments in a borrower’s credit history. According to HUD guidance, the lender must determine if the negative marks result from “a borrower’s disregard for financial obligations, the borrower’s inability to manage debt, or extenuating circumstances” — all of which could impact the borrower’s ability to pay back their loan.

Fannie Mae, a government-sponsored entity that guarantees mortgages issued by private lenders, offers similar guidance for “extenuating circumstances” in a borrower’s history that resulted in reduced income or increased financial obligations. Lenders must obtain a letter of explanation and supporting documents, like medical bills or tax returns, that indicate why the borrower defaulted on his or her financial responsibilities.

Bill Banfield, executive vice president of capital markets at Quicken Loans, told LendingTree that letters of explanation simply help underwriters better understand a borrower’s dynamic financial situation.

“The question is, how complicated is it, and can a third party who doesn’t know you personally connect the dots,” he said. “And if there are questions, all it is is really a conversation, and they’re just trying to document it in the file so that people understand how they reached the conclusion on you being eligible for the loan.”

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Why might a lender request a letter of explanation?

A lender will likely require a letter of explanation for anything out of the ordinary in your financial history. These situations may include:

  • Address discrepancies. Your past and current addresses appear on your credit report. If there’s an incorrect address listed, or if you have overlapping addresses, you may be asked to explain the discrepancy. This can happen to parents who rent apartments for their college-age children, for example. When parents go to refinance their own home, it might appear that they don’t actually live at the property.
  • A job change or gap in employment. If you have been laid off or were unemployed for a period of time, you may need to explain the circumstances — especially if this gap resulted in a default on any financial obligations. Job severance papers and tax returns from before and after the loss of employment can help clarify the situation.
  • Large deposits to your bank accounts. An underwriter may require an explanation for large sums deposited into your accounts if they can’t identify the source. One example: You sold your car to a private buyer for $7,000 cash. You may be asked to provide a paper trail, including deposit slips, canceled checks or verification of a wire transfer.
  • Late payments and past-due credit. Lenders, and the entities that back them want to know that you’ll be able to make your mortgage payments on time and in full, and a history of derogatory marks on your credit report doesn’t look good. One late payment probably won’t raise much alarm, but you’ll need to explain the circumstances — you had an emergency medical issue that required a hospital stay and significant expenses over several months, for example — if you’ve had multiple past-due accounts or missed payments in a short time frame.
  • Changes in income. If you’ve experienced a gap or dip in income — you took several months off to travel, had a baby, got divorced or left a salaried position to start your own business — your letter should clarify this change. If you’re self-employed or your reported annual income isn’t supported by documentation, an underwriter will likely want to understand why. Again, lenders just want to know that you have a reliable source of income to cover your mortgage payments.
  • Other extenuating circumstances. You may need to explain inquiries that appear on your credit report and state whether you were approved or denied for those lines of credit. Overdraft fees and large withdrawals may be cause for concern if it appears as though you have trouble managing your finances, so you should explain these situations as well. If you’ve been the victim of identity theft or credit card fraud, include this in your letter.

Michelle Velez, production manager at Supreme Lending and secretary of the National Association of Mortgage Brokers, said that most borrowers will be required to write and submit a letter of explanation to their lender. Generally, borrowers should include a letter with their initial application paperwork, she added.

“It just makes it easier, and it makes [the application] make sense,” she said. “If [the letter is] not provided at the start of application, typically the underwriter will ask for it.”

If you don’t submit a letter of explanation up front, it’s not a deal breaker. It just means that the underwriting process may take longer as you collect all the necessary documentation and ensure your letter fully explains any issues that arise.

“You’ll get the approval, but it’s a conditional approval,” Velez said. “It’s conditional on providing explanations for this thing, this thing and this thing. It’s conditional on making sure that there are no questions on the application, because when the investor looks at the file or they go through compliance, if there’s anything that could be considered questionable, then they won’t move forward.”

How to write a letter of explanation

The key to a good letter of explanation is to cover all possible derogatory marks, gaps and extenuating circumstances that may catch the underwriter’s attention. Be specific, and include dates, details and supporting evidence for each scenario you describe.

“If it’s not clear and concise and it doesn’t make sense, and if it doesn’t answer the questions the underwriter is looking for, they will definitely ask for additional information, meaning documentation to back up that letter of explanation,” said Velez.

While letters of explanation generally are typewritten, Banfield noted that lenders may accept letters in any form, from handwritten with pen and paper to email. For example, Fannie Mae’s guidelines state that borrowers can submit email explanations.

“I think it really speaks to the spirit of what you’re trying to accomplish, which is to accurately convey the situation to help somebody that doesn’t know you personally understand how to qualify you for the loan,” he said.

Regardless of how you submit your letter, use a standard business format, address it to your underwriter or mortgage company and include your name, the date and your contact information.

Your loan officer can help you collect supporting documents and compose your letter. It should include:

  • Facts and supporting evidence for each issue. Include specific dates and dollar amounts, and avoid placing blame for any negative situation
  • Steps you took to resolve each issue and the date of resolution
  • Specific steps you’ve taken to ensure the situation doesn’t happen again
  • Documentation, such as medical bills, credit card or car loan statements, divorce papers and tax documents, that backs up your explanations and timelines
  • Your signature

Check your letter for spelling, grammar and formatting issues before you submit it, and follow your loan officer’s instructions.

A letter of explanation helps your lender understand you better. Use it as an opportunity to show that you are a responsible borrower who can manage big financial obligations like a mortgage.

“There’s a little bit of human discretion involved when a lender is going to ask for something, but it’s always rooted in the same thing: Just help me understand,” Banfield said.


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