Your lender might ask you for a letter of explanation during the underwriting process. A letter of explanation is a short explanation you can use to fill in the gaps in your paperwork for your underwriter. Letters of explanation might sound like a pain to write, but the truth is that these letters can actually help you get a loan more easily.
We’ll explain what letters of explanation are and why you might need to write one. We’ll also give you a sample template you can use to draft your own letter of explanation.
What’s A Letter Of Explanation?
First, let's go over what exactly underwriting is. During the underwriting stage of a mortgage, the mortgage company decides whether you qualify for a loan. A mortgage company does this by reviewing the financial documents you submitted with your application. Mortgage companies use finance professionals called underwriters to oversee underwriting. An underwriter’s job is to assess your risk and decide whether you’re a good candidate for a home loan.
The information the underwriter sees doesn't always tell your entire financial story. An underwriter may request a letter of explanation from you if they’re unsure about something they see. A letter of explanation is a brief document you can use to explain anything in your financial or employment documents that might make an underwriter pause. For example, you may need to write a letter of explanation if you have unusual or sudden activity in your credit report or banking statements.
Don’t assume your lender won’t be able to give you a loan if they need one of these letters. The opposite is often true. They might simply need more information about your credit report or bank statement.
Letters of explanation are requirements for secondary authorities that own or back the loan in many cases. The Federal Housing Administration (for FHA loans) and Fannie Mae or Freddie Mac (for conventional loans) impose their own underwriting standards on lenders. Many of these guidelines dictate that the lender must get a letter of explanation for certain items on borrowers’ reports. Think of a letter of explanation as an underwriter’s way of saying, “We know this item is here, and we’ve looked into it.”
Why Do I Need To Provide A Letter Of Explanation?
You may need to provide a letter of explanation for your lender if you have any of the following items on your credit report or bank statements.
Negative Items On Your Credit Report
Lenders need to know you have no trouble managing your finances. Negative items on your credit report can set off red flags for underwriters who might assume you have difficulty paying your bills. You may need to provide a letter of explanation for any negative items on your credit report including missed payments, defaulted loans or repossessions.
Your income may change from month to month if you’re self-employed. Therefore, an underwriter might have trouble distinguishing which deposits are your income and which are gifts or grants. You may need to provide a letter of explanation that clarifies your average monthly income if you’re self-employed.
Unusual Large Deposits
Lenders need to know you aren’t using a loan to pay for your down payment, which would increase the chance you’ll default on your mortgage loan. Your lender will want to know why you have large deposits that don’t match up with your current income.
Unusual Large Withdrawals
Like large deposits, large withdrawals can also trigger red flags for underwriters. Some government-backed loans (like FHA loans and USDA loans) have income limits. Sudden large withdrawals might signal that you’re hiding your income to qualify for a special loan. It can also mean you’re about to make a large and risky financial move. Expect your lender to ask for a letter of explanation if you have any unsourced withdrawals on your bank statements.
New Accounts On Your Credit Report
Applying for a lot of credit or loans at once might mean you’re getting ready to make a very risky financial move. A mortgage is a large loan, so any new accounts on your credit report will set off red flags for your lender.
You may need to write a letter of explanation letting the lender know why you opened new accounts around the same time as your application.
Overdraft Fees On Your Bank Statement
You’re a major risk for mortgage lenders if you don’t manage your money well. An underwriter might see an overdraft fee on your bank account and assume you have trouble managing your money.
You might need to write a letter of explanation if you have regular overdrafts on your account, but a single overdraft fee may not trigger a red flag.
Gaps In Your Employment History
You need a steady and reliable income to keep up with a home loan. Your lender might assume a gap in your employment history means you’re at a higher risk of falling behind on your bills. Along with a copy of a new job offer, a letter of explanation can give your lender more confidence in your employment.
A Large Amount Of Debt Compared To Your Income
You might already have some debt in the form of student loans or credit card bills. However, having too much debt can make you more likely to fall behind on your mortgage payments. This is especially true if you don’t have enough income to cover all your expenses each month.
Make sure you know and understand your debt-to-income (DTI) ratio before you apply for a loan. Your underwriter will ask you for a letter of explanation to learn more about your situation if your DTI is more than 50%.
Primary Occupancy Concerns
You must live in a home for most of the year to qualify it as a primary residence. Different rules apply to secondary residences and investment properties. Some types of government-backed loans are only offered for primary residences.
Buying another primary residence even though you already own one? Your lender might ask why, especially if you don’t plan to sell your current primary residence. Your lender will request a letter of explanation if they have concerns about where your primary residence is actually located.
How To Write A Letter Of Explanation
Letters of explanation are a fairly common part of the mortgage application process. Make sure your letter of explanation includes:
- The current date (the day you write the letter)
- The name of your lender
- Your lender’s complete mailing address and phone number
- A subject line that begins with “RE:” and includes your name, application number or other identifying information
- One or more paragraphs that provide information the lender asked for. Be as detailed as possible and include dates, dollar amounts, account numbers, etc.
- Any identifying documentation that backs up your claims (copies of bills of sale, title transfers, marriage licenses, etc.)
- Your full legal name as it appears on your mortgage application
- Your spouse or partner’s name if they’re on the loan application with you
- Your full mailing address and 10-digit phone number
- A polite closing
The key to writing a great letter of explanation is to keep it short, simple and informative. Be clear and write with as much detail as you can since someone else will need to understand your situation. Avoid including irrelevant information or answers to questions the underwriter didn’t ask. Be polite but not overfriendly and don’t use emotional language.
After you finish writing the letter, edit for typos or grammatical errors. Send the letter in a timely manner to get your loan application in on time.
Here’s a sample letter of explanation. You can use it as a template when you write your own letter.
July 15, 2019
Sample Lending Company
123 Lending Lane
Brooklyn, NY 11207
RE: Jessica Smith’s Mortgage Loan Application
To Whom It May Concern:
I’m writing to you to explain the deposit of $8,800 which went into my Brooklyn Bank checking account on June 10, 2019. I deposited funds I received from the sale of my 2001 Mazda 6 which I sold on June 8, 2019 to Mr. John Smith. Enclosed is a copy of a receipt for the sale of the vehicle as well as a copy of the title transfer.
150 Same Drive
Brooklyn, NY 11207
An item on a credit report or bank statement can trigger a red flag for the underwriter, so your lender may ask you for a letter of explanation. A letter of explanation is a brief letter you can use to explain items on your financial documents. A decline in income, self-employment income, negative credit items and overdraft fees may all require letters of explanation.
The key to writing a good letter of explanation is to keep the letter short, straightforward and simple. Include all the information the lender requests. Don't include any excess information the lender didn't ask for. Be polite but not overly friendly. Include any supplemental documentation that backs up the claims you make in the letter. Mail the letter promptly to keep your mortgage application on track.
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