If your credit report has any negative history, or if there is something in your mortgage application that requires more information, a lender may ask you to submit a "letter of explanation." This isn't a cause for panic. You can consider the letter request as an opportunity to clarify something that the loan underwriter needs to resolve before approving your loan. Here's what you should know.
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What Is a Letter of Explanation?
A letter of explanation is your chance to answer any questions a lender might have about your loan application. This can range from a gap in your employment, to a gift you received from your family, to a collection action in your credit report. It's designed to give the underwriters -- who are tasked with finalizing the loan - all the information they need while they analyze your application.
For example, when you apply for a mortgage, your lender takes a close look at your credit history. Specifically, lenders check for derogatory marks on your credit report, such as late payments, delinquencies, charge-offs, bankruptcies, foreclosures and judgments.
Underwriters are often required to get letters of explanation for certain application-related issues. There are guidelines set by the secondary organizations that back or buy the loans, such as the U.S. Department of Agriculture, U.S. Department of Veterans Affairs, Federal Housing Administration, or Fannie Mae and Freddie Mac. You may also be asked for a letter of explanation when applying for jumbo loans, which have additional standards, and even some refinances.
When a lender asks for a letter of explanation, you can take it as a good sign because you haven't been rejected outright. It gives you an opportunity to share additional details that could sway approval. It could be that everything on your loan application looks good, except for this one thing you need to explain.
Situations That Might Require a Letter of Explanation
Lenders could ask for a letter of explanation if anything in your credit history or financial situation raises an eyebrow during underwriting. Jackie Windham, senior vice president of mortgage lending at SouthEast Bank in Tennessee, says a lender could ask for a letter for any of the following reasons:
-- There are late payments, collection accounts, judgments or bankruptcies on your credit history.
-- The name and address on your credit report don't match the name and address you've provided on your mortgage application.
-- There are discrepancies between the employment history you report to the mortgage lender and what's listed on your credit reports.
-- You have an active fraud alert on your credit reports.
Unrelated to your credit reports, Windham says a lender may ask for a letter to explain issues with your bank account, such as overdrafts, unusually large deposits or withdrawals, or large transfers between accounts. Your lender might also ask for an explanation if you hold a joint account with someone else but are applying for a mortgage in your name only.
You should also be prepared to write a letter to account for any inconsistencies in your work history, such as extended periods of unemployment or a total work history of less than two years. And a lender may ask you to explain big swings in your income if your tax returns or pay stubs show some significant ups and downs.
"The letter of explanation is the underwriter's way of showing that an item needs further explanation," Windham says.
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Sample Letter of Explanation
If your lender asks for a letter of explanation, you'll want to state what the issue is and, if needed, describe how it was resolved. You won't need to write a long letter -- just stick to the facts. Windham offers a letter of explanation sample for an address discrepancy:
To Whom It May Concern:
In response to the underwriter's request, I'm sending this letter to explain the differences in my address. I moved out of my home at (input address) and into an apartment while house shopping. Not knowing the exact time frame I would be living in an apartment, I changed my mailing address to my mother's address at (input address) so that I would receive all mail.
Please let me know if there are other questions.
Shashank Shekhar, CEO and founder of Arcus Lending in San Jose, California, says your letter should include all of the relevant information the lender asks for, presented in a way that gives a clear picture of your situation.
"While staying truthful, provide details that will help you prove your side of the story and get your loan approved," he says. "For example, if you had many job changes in the past, provide the reasons why you had to leave those jobs and how you are committed to staying at the current job for the long term."
Can You Avoid Having to Write a Letter of Explanation?
Shekhar says it's possible that you may be able to preempt having to write a letter of explanation by sharing any potentially problematic financial circumstances with your lender at the outset. While there's no guarantee that you won't still need to provide a letter, you can give your loan officer a better sense of your ability to repay if you're upfront about past credit mistakes or financial challenges.
Additionally, there may be some things you can do before you apply for a mortgage that could reduce the odds that you'll need to submit a letter of explanation. Here are three strategies Windham recommends:
-- Hold off on applying for new credit in the 120-day window before applying for a mortgage. Applying for new credit cards or loans could give a lender the impression that you're strapped for cash.
-- Avoid overdrafting your bank account within that same time frame. Overdrafts don't show up on your credit report unless the overdraft is sent to collections, but you don't want lenders to assume you struggle with managing your bank accounts.
-- Pay all of your bills on time each month. Payment history accounts for the largest share of your FICO credit score, and late payments can be highly detrimental to your credit rating.
If you have unpaid collection accounts on your credit, you may question whether it's worthwhile to pay them off before applying for a home loan. The answer is, it depends.
Paying off a collection account won't necessarily get you out of writing a letter of explanation; the lender may still want to know why the account became delinquent. Collection accounts can still remain on your credit report for up to seven years, even when they're paid off. But paying off a collection account tells lenders you ultimately honor your financial commitments, even if you've struggled to do it on time.
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Could a Lender Reject Your Letter of Explanation?
Both Shekhar and Windham say yes, it's possible that a lender might review your letter of explanation and reject it. The main reason? The letter doesn't fully clarify the issue your lender is asking about.
If that happens, draft a new letter of explanation. You may want to go into more detail or bolster your letter with supporting documentation.
For example, say that you defaulted on a personal loan because you got sick and couldn't work for a couple of months. Sharing copies of your medical bills gives the lender some context as to why you weren't able to keep up with the loan. Or it could be that the medical bills themselves are outstanding, so sharing those documents may strengthen your case for a mortgage.
If a lender still isn't willing to give you a home loan after you resubmit your letter of explanation , you might want to consider applying with another lender. However, you will have to restart the loan process, and it's likely you will need to offer another letter of explanation.
Another option is to delay your home search in the short term. You could then take time to work on cleaning up any negative credit items. This will also create some distance between the timing of your application and your previous credit problems.