Letters of Explanation

Every mortgage applicant will have their file go through underwriting. Underwriting is the final check to ensure you’ll be able to fulfill your obligation of making payments on time.

In some situations, you may be asked to provide a “letter of explanation” to address specific financial concerns. This often occurs when something about your finances changes after you received pre-approval for a loan. It never occurs just because the lender has a “gut feeling” about an applicant’s personality or any other subjective factor.

Let’s learn about how and why mortgage letters of explanation are written.

» READ MORE: I was Pre-Approved for a Mortgage, then Denied - Now What?

What is a letter of explanation?

A letter of explanation is your opportunity, as a mortgage loan applicant, to address an underwriter’s concerns about your application. It could involve information that appears to be inconsistent, gaps in the available information, or certain events that require explanation. The underwriter will take a detailed look at a substantial amount of information about you, including the following:

• Credit score

• Credit report

• Tax returns

• Bank statements

• Debts, such as credit cards and student loans

• Current income and income history

• Employment history

• Rental history

• Other obligations, such as child support or alimony

When an underwriter asks for a letter of explanation, you can describe the situation in your own words. This can provide a more nuanced understanding of the situation than the underwriter could get from looking at bank statements, tax returns, or other documents.

» READ MORE: Do's & Don'ts of Using Cash During the Mortgage Process

“Does my mortgage lender think I’m a criminal?!”

If a mortgage lender asks you to provide a letter of explanation, it is because they are required by federal law to do so. They do not necessarily suspect you of criminal activity. They are required to request additional information to protect themselves, their mortgage company, and their clients.

Mortgage lenders have another reason to request a letter of explanation when an underwriter finds large transactions that appear out of the ordinary: federal law requires them to do so. The Bank Secrecy Act (BSA), as amended by the Patriot Act, requires financial institutions to monitor certain types of transactions and report suspicious activity to law enforcement.

Mortgage lenders count as “financial institutions” under the BSA. If lenders find any activity deemed suspicious during underwriting, they must review it further. The government agencies enforcing the Bank Secrecy Act consider unusually large deposits or withdrawals (among other things) to be possible signs of money laundering, involvement in terrorism, or other illegal activities. Mortgage lenders investigate by requesting letters of explanation.

Why Mortgage Letters of Explanation are Needed

A request for a letter of explanation can arise from almost any part of your loan application. Many requests are based on concerns about creditworthiness. There are also specific guidelines according to the loan program you’re interested in.

Here are some reasons why a mortgage lender may request a letter of explanation from you:

Negative Credit Report Information

If your credit report shows a significant amount of credit problems, the underwriter might ask for a letter of explanation. Issues that could lead to a request include the following:

• Large numbers of credit inquiries

• Missed or late payments

• Charge-offs

• Accounts in collection

• Foreclosures

• Bankruptcy

Gaps in Employment History

Mortgage lenders want to see two or more years of consistent employment, ideally with the same employer or in the same field. This demonstrates that you have a dependable source of income and will be able to make your mortgage payments. Gaps in your employment history can be a cause for concern. Underwriters may also be concerned if you have changed jobs frequently or made a significant change in the course of your career, such as leaving a lucrative job to work in a position with much lower pay. Self-employment can also lead to a request for a letter of explanation since you might not have as much of a paper trail demonstrating your income.

Gaps in Rent or Mortgage History

Much like how steady employment history shows the ability to make regular payments, a consistent history of rent or mortgage payments demonstrates that you are dependable. If you do not have recent rental history, such as if you have been living with a parent, the underwriter will want more information. In this situation, the letter of explanation might have to come from the owner of the home where you’ve been living.

Unusually Large Bank Deposits or Withdrawals

Underwriters do not look at your bank account simply to see that you have enough money there to make a down payment. They want to see that you consistently maintain enough of a balance in your account to allow you to make regular payments of principal and interest. This is known as “source and seasoning.” They also want to see if you recently made any unusually large transactions. If, for example, your bank records indicate that you received the money for a down payment from someone else, and not from your own income, you may need to submit a gift letter as well as a letter of explanation.

» READ MORE: Mortgage Gift Funds: Basic Information

Long Distance between the Property Address and Your Work Address

Mortgage lenders have stricter standards for loans used to purchase a home that will not be your primary residence. If the home you want to buy is far away from where you work — typically more than 50 miles — the underwriter may suspect that you are buying an investment property or vacation home.

How to Write a Letter of Explanation for a Mortgage

If a mortgage lender requests a letter of explanation from you, ask if they have a particular form or template that you must use. If not, you can format it as a letter. You should include the following information:

• Your full name, as shown on the mortgage application

• Your address and phone number

• Your spouse’s full name if they are also an applicant

• The date of the letter

• Your lender’s name and address

• A subject line with your loan application number

• One or more paragraphs that provide the requested information

• Any documentation that supports your explanation

The following tips can help you draft the main body of the letter.

Keep It Short and Simple

A few paragraphs will be plenty for most letters of explanation. You just want to provide the information that the underwriter needs to understand what happened. For example, if your credit report has incorrect negative information because you were the victim of identity theft, explain what happened and what you did or are doing to deal with it. If you had a break in employment because of an injury, provide information about any unemployment or worker’s compensation claims during that time.

Include Evidence

Attach documents that support your explanation. In the examples above, you could attach police reports and court paperwork relating to your identity theft case, or documents showing your unemployment or worker’s comp benefits.

Be Honest

You are writing this letter because the underwriter has concerns about your creditworthiness. Do not try to minimize or deny those concerns without solid evidence. Answer the underwriter’s questions as honestly as you can.

What happens if my letter of explanation is rejected?

Submitting a letter of explanation does not guarantee that the underwriter will approve your application. Rejection does not necessarily mean all is lost, though. You may be able to try the following:

• Ask if you can submit an amended letter of explanation or additional documentation.

• Work to repair the issues that led to the underwriter’s concerns, such as a gap in employment or rental history.

Ready to buy a home?

A mortgage lender is taking a risk when they give you money. There’s a chance (however small it may be) they’ll give you money they’ll never get back. On top of that, the federal government wants to protect its citizens. That’s why we have to follow a stringent process.

At The Wood Group of Fairway, the mortgage process is easier, faster, and friendlier than you may expect. We treat your loan like it’s our own. Answer a few easy questions online and we’ll get in touch with you about your best mortgage options!