If you’re purchasing a home, you already know that lenders have many questions regarding your finances, your job, and your ability to afford mortgage payments. When you apply for a mortgage, especially if you’re a self-employed earner, lenders will ask you specific questions regarding most aspects of the mortgage application. When this happens a letter of explanation can provide clarity to lenders so that they can better understand your financial situation.
Oftentimes in the loan process, if there are any red flags or confusion regarding your financial situation the lender will want clarification. Lenders look in great detail in the financial situation of the borrower. This might occur when a borrower has a student loan default, medical bills, or an otherwise obscure negative event on their credit rating that needs an explanation.
Purpose of Letter of Explanation
A letter of explanation is a letter written by the prospective borrower stating why or how something occurred, such as why they fell behind on student loan payments or a medical bill. Because credit and income are the major components of a loans approval, the lender will focus their efforts on one’s income and credit. This is the aspect that most borrowers will typically write a letter of explanation on.
Underwriters and lenders especially in the current economic climate place great emphasis on your finances and credit. If there are any issues with either your income and/or credit, a letter of explanation will be a great way to help underwriters understand your current financial situation.
Why is a Letter of Explanation Useful?
When an underwriter has questions regarding your finances or credit, a letter of explanation might oftentimes be the only thing that can salvage one’s ability to retain a mortgage. There are many different instances when a letter of explanation can prove vital in explaining your situation.
While it is true that lenders have debt to income ratios, maximum LTV ratios, and income requirements that must be met, when the borrower meets most of the requirements however not one or a few, the lender might entertain the idea of issuing a loan approval, even without a perfect loan application. The loan underwriter reviews loan documents.
Letter of Explanations Provide Context Where Numbers and Figures Cannot
Even if the application is not ideal, underwriters have a responsibility to read between the lines and understand the whole picture, rather than just simply your review your application. If this were not the case, there would never be a need for an underwriter, and lenders would solely rely on computers to make decisions. Fortunately, this is not the case as underwriters have the power to review case specifics.
For example, when your bank account balances change dramatically over the course of a few months the lender will certainly have reservations understanding why. A letter of explanation can help the underwriter understand why bank account balances have fluctuated. Another example of when a letter of explanation might be necessary is when there is a negative item on your credit report. Oftentimes, many borrowers aren’t even aware of the negative item on the credit report, or the item might be obscure, such as a very small bill from years past that went to collections. If the item on the report is so small and obscure, the lender will likely not penalize the borrower for the item if the borrower writes a solid letter of explanation.
When Is a Letter of Explanation Potentially Needed
When an applicant has changed jobs within the last few months
Borrower has drastically different account balances throughout the month
When there is a gap between employment
When the borrower is experiencing a reduction in income
When the borrower defaults on a debt, likely a student loan or medical bill
Borrower has obscure hits on their credit
Previous delinquencies that need to be explained
Purpose of purchase (primary residence, investment property)
In instances such as these, a letter of explanation can dramatically improve the prospective borrowers ability to retain a loan because the underwriter has the means to understand the applicant’s situation better.
Avoiding a Letter of Explanation
While it is true that a letter of explanation provides borrowers with a medium to help lenders and underwriters interpret the financial situation of the borrower, it is advised that loan applicants do everything in their power to avoid a lender from even having questions in the first place. The more reasons an underwriter has to question the file, the greater the likelihood that the borrower gets denied for a loan. This is something to keep in consideration.
To avoid requests for explanations, loan applicants should make it as easy for underwriters to review the file. This involves sending complete documents with no pages missing, easy to read applications and signatures, and consistent monthly balances in an applicant’s bank account. Furthermore, the easier it is for the underwriter to review the file, the greater the chance the borrower will be approved for a loan.
One of the main reasons loan applicants hire mortgage brokers is to help them package their application in a manner best equipped to be approved. Brokers oftentimes have relationships with underwriters and know what they are looking for. For this reason, it is recommended for a mortgage applicant to reach out to a broker prior to submitting a loan application, particularly when the borrower is self employed and/or has a more difficult mortgage.
Writing a Letter of Explanation
The letter of explanation is meant to further explain a situation that may easily not be possible to transmit through financial documents. As explained above, the main concerns an underwriter will have involves the borrower’s credit and income. Be prepared to state in words what the underwriter is looking at.
For example, if an underwriter discovers a borrower has a past due medical bill, the applicant should be ready to state why the account fell past due. The applicant surely should not say that they fell behind because of their inability to afford it because this is a red flag to the underwriter that the applicant does not have the ability to afford mortgage payments. Typically, the best response for an item like this might be that the applicant had a dispute with the medical facility and that they got penalized in return, however are resolving the issue now or that it was a mistake.
The letter of explanation should include the date, name of the party, reason for the letter, and the explanation concerning the aspect of the application that the underwriter had questions about.
Sample Letter of Explanation
To Whom This May Concern,
This letter is intended to explain the circumstances concerning my unusually high bank deposits the last few months. I typically make the same income almost every month, however the last few months I have sold a few expensive assets of mine that has increased my bank account balance. I sold my car 2 months ago, which explains the sudden $24,000 deposit. Also, last month I sold a few pieces of business equipment I used to use for my business. The total for my business equipment was valued at $19,250. Both the deposits were a onetime deposit and will not happen again. My average monthly income is $12,500 based on my last 12 months income. If you have any questions regarding my income, please let me know, however that is generally the only income I receive, and it is always consistent. Thank you.
As can be seen above, the letter clearly states the reasons why the borrower had unusually high deposits. Any underwriter who reads that letter would clearly understand why the applicant made these deposits and where they derived from. The letter above is not difficult for anyone to write, however greatly increases the ability of the underwriter to recognize the financial situation the borrower faces. For this reason, letter of explanations is vital when an underwriter does not understand a portion of the applicant’s loan application.