Underwriters are kind of like detectives: They’ll investigate anything in your financial history that looks out of the ordinary to try and get to the truth. If you’re applying for a mortgage, you can expect underwriting teams to scrutinize your finances, credit reports and employment records. That’s why it’s so important to get all of your monetary ducks in a row before heading out to buy a new house or refinance a mortgage.
But that doesn’t necessarily mean that any red flags in your loan application will sink your prospects of securing a mortgage or a good interest rate. You’ll likely have an opportunity to tell your side of the story and clarify any potential concerns with your financial situation.
A letter of explanation can be a great way to ease any concerns about your loan qualifications or creditworthiness. Underwriters may request such documents if they want more details about your finances, debt obligations or work history. Not everyone’s a born wordsmith, however, which is why we’ve put together this guide to help you both understand explanation letters and learn how to write a letter of explanation for mortgage lenders.
When you apply for a mortgage, your lender’s underwriting team will pore over your financial history to look for any potential red flags in your loan qualifications. First and foremost, underwriters want to know if you have the cash flow to stay on top of your mortgage payments and repay your loan balance. They’ll also check that you have a strong track record of paying down debt and managing your finances.
But if underwriters find potential causes for concern in a loan application, they may ask homebuyers to write an explanation letter.
A letter of explanation — sometimes abbreviated as either LOX or LOE — is a written document that supplements your financial records and directly addresses potential concerns regarding your loan qualifications. Explanation letters provide details and context that underwriters would otherwise not be able to glean themselves. In particular, underwriters will request a letter of explanation when they spot issues like derogatory credit, large deposit, cash flow problems and gaps in employment.
The borrower — that means you — will be responsible for writing the letter of explanation. Your real estate attorney, loan officer or real estate agent may offer some guidance on what information to include, but at the end of the day, you’re going to need to sit down and draft the letter yourself. After all, no one knows your past better than you.
Mortgage loan processes rarely provide much context for underwriters to consider beyond the financial documents that are submitted. Underwriting specialists may see a gap in your employment history, for instance, but they probably won’t know if you paused your career to stay home with your children or take care of an ailing relative. Filling in the details can be helpful for both lenders and borrowers, which is where an explanation letter can come into play.
Underwriters may request a letter of explanation for a number of scenarios, ranging from relatively minor incidents to extreme financial distress. Here are some of the most common reasons underwriters will ask to see an explanation letter:
These conditions could indicate that you’re a risky borrower. But there just as easily could be fairly benign — or at least perfectly understandable — reasons for many of these red flags:
Lenders can be pretty sympathetic about extenuating circumstances that negatively impact your finances. So, don’t feel stressed out if you’re asked to present an explanation letter. Your mortgage company just wants to get the full story behind your financial history. There’s no reason this kind of request needs to derail your plans to buy a home.
As long as you’ve acted in good faith, you shouldn’t worry too much about the fallout from writing an explanatory letter. If you can give a compelling reason for your actions, even the most seemingly damaging financial misstep could be rationalized. The only times a letter of explanation could blowback on a borrower would be if you provided false information in your account, admitted to illicit activity or simply lacked a compelling reason for your actions.
Having said that, don’t submit an explanatory letter unless your lender asks for one. Writing an unsolicited letter of explanation could just draw attention to qualification concerns that the underwriting team wasn’t too concerned about to begin with.
As we highlighted above, there are plenty of scenarios that may raise red flags with your mortgage provider. The type of explanation letter you write really depends on the specific situation you’re trying to address. These are the most common letters of explanation you may be asked to write:
Writing a letter of explanation can be daunting, especially for first-time homebuyers. When it comes time to put pen to paper, your mind may draw a blank, even if you have a perfectly good reason for any issues that come up with your loan application. You don’t need to reinvent the wheel here. Following a letter of explanation template will help ensure you provide the right information and present your case in a way that’s easy for underwriters to scan and digest. Feel free to use this explanation letter sample as a guide:
Your contact info (name, address, phone number, email)
Your loan application info (lender’s name, application number, loan officer’s name)
Your greeting, ideally addressed to a specific person but “To whom it may concern” can work in a pinch)
Paragraph #1: Acknowledge the underwriter’s request for an explanation letter and the specific issue at hand
Paragraph #2: Explain the circumstances surrounding that issue. Be brief and try to stick to the facts.
Paragraph #3: If applicable, provide more context as far as how you have addressed that issue and how your financial situation has changed for the better.
Paragraph #4: Note any additional documentation that you’ve included with your letter: bank statements, receipts, copies of bills, etc.
Closing: Thank the recipient for their assistance and offer to provide more information or documentation if need be.
Sign-off with your name: Keep things relatively formal and polite when signing your letter. “Sincerely,” “best” and “regards” are all fine closings.
Hopefully, our example of an explanation letter gives you plenty of concrete steps to take if your lender requests this extra step in the mortgage process. That being said, here are a few more tips to follow when writing a letter of explanation:
Mortgage lenders — underwriters, more specifically — may request a letter of explanation if they find potential red flags in your loan application. Common issues can include unpaid bills, loss of income and unusual bank deposits.
An explanation letter isn’t necessarily a huge cause for concern, however. If your financial situation has improved since the incident in question or there are extenuating circumstances to consider, a letter of explanation can help clear the air.
A good lender will work with you to review your finances and find a type of home loan that fits your circumstances and needs. So, don’t fret if an explanation letter comes up during your loan application. Sit down with your mortgage specialist to figure out exactly what information to include so you can move past this bump in the road and secure a home loan.
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