A letter of explanation is a document that provides context to your financial profile. If everything in your application looks normal, then a letter of explanation isn’t needed. But if there’s some issue with your credit or employment history that gives the underwriter cause for concern, they may ask you to provide a letter that explains what happened.
Don’t panic if you receive this request because they would simply deny your application if the issues were too severe to overcome. But it’s essential to gather the evidence and present your case as clearly as possible so you won’t be denied or stuck with a higher interest rate.
Issues with Your Credit History
The most common reason an explanation letter is needed is to address any problems with your credit report. Potential issues include bankruptcies, late payments, foreclosures, collections, and any other blemish on your record that may cause concern. If an underwriter sees these issues, they will want to know exactly what happened and what you’ve done to remedy the situation.
Gaps in Your Employment History
Gaps in your employment history are another red flag that may cause concern to many lenders. Most underwriters want to see at least two years of solid employment history without major gaps. But if you’ve recently changed jobs or taken time off for personal reasons or to go back to school, you may be able to convince them to look past this rule with an explanation letter.
Fluctuation in Income or Business Losses
Lenders like to see stable, predictable income. But if you’re self-employed, your income may not be the same each month, or you may even report a loss on your taxes. But, if you can prove you have the funds available and other assets to fall back on, you may be able to explain this fluctuation in a letter of explanation.
Remote Work Approval
If you work remotely, a lender may request approval from your employer that you are allowed to work outside their office. Otherwise, they may be confused if you attempt to purchase a home in a completely different city or state than where they’re headquartered.
Suspicious Bank Account Transactions
If the underwriter notices large, unexplained back account transfers outside your normal income, they may ask for an explanation. There could be a perfectly reasonable explanation, such as you were given a bonus or you received a cash gift from a relative to help pay for the down payment. But they’ll still want to double-check that you aren’t trying to trick the system.
You’ve Been Living Rent Free
The underwriter will want to see a solid rental or mortgage history on your application. So if you’ve been living with a relative and don’t pay rent, they’ll want to see a letter from the homeowner proving that you’ve been living with them. Otherwise, they may assume that you’re hiding information because it may reveal something negative.
1. Use a Template
When writing a letter of explanation, it’s best to use a template to format it correctly and include all the necessary information. If you write it off the cuff, it may appear disorganized or fail to include all the required info. You can use the template below if you need help.
2. Be as Detailed as Possible
Try to be as detailed as possible with your explanation, and don’t just give vague answers that fail to address the problem. You don’t have to write a novel, but the better you present your case, the better the odds that the underwriter will believe your account.
3. Provide Evidence
Include as much evidence as possible to prove your claims. For instance, if you experienced financial problems due to a death in the family or a divorce, provide documents from the probate or divorce court. The more facts and evidence you give to back up your assertions, the easier it will be to persuade the underwriter.
4. Highlight the Resolution
Even if you have a solid excuse, no lender will approve you for a loan if you’re still in a challenging financial situation. Instead, they recommend you remedy the problem first, then apply for a loan. So, if you want to be approved right away, address the circumstances and highlight what you’ve done to turn things around.
5. Show a Commitment to Change
Everyone makes mistakes, but if you want an underwriter to overlook these past issues, you’ll have to show a commitment to change. Let them know how you’ve addressed the problem and what you’re currently doing to stay on track. An explanation letter doesn’t completely absolve you of responsibility but gives you the ability to tell your side of the story, which includes your efforts to improve your situation.
Name of Lender
Dear ___________ [include the name of the underwriter or address it as “to whom it may concern” if you aren’t sure]
[paragraph explaining the issue you’re addressing]
I’m providing this letter to explain the bankruptcy that was filed on April 15th, 2016.
[paragraph explaining the circumstances that caused the issue]
My wife and I filed for divorce on November 3rd, 2014. I accumulated a lot of credit card debt, paid legal bills, and got in over my head with creditors. So, I was forced to declare bankruptcy to get a fresh start.
[paragraph explaining what you’ve done to fix the issue]
The bankruptcy was over 5 years ago, and I’ve since gotten back on my feet. I have not missed a payment in the past three years, and I’ve rebuilt my credit as much as possible to prove I’m committed to improving my finances.
[include any proof you have to back up your claims]
Attached is a record of the divorce proceedings and bankruptcy filings, as well as a letter from my credit repair specialist proving that I’ve increased my score by 50 points over the last three years.
Please contact me at [phone number] or [email address] if you have any additional questions or concerns.
Having a few blemishes on your credit report isn’t the end of the world, especially if you can show that you’ve been committed to fixing the issue. But, if you want to be approved for a home loan, you will need to provide solid evidence of this in an explanation letter. The more thorough and detailed you make the letter, the better the chances are that the underwriter will empathize with your situation and approve you for the loan.