When you made the mortgage application you provided the loan officer with bank statements, W-2's, pay stubs, and tax returns for two years. You even had your first grade class picture ready. You thought that you nailed the paperwork, but then the loan officer informed you that the underwriter wants a letter of explanation regarding a few late payments on your credit report. Your reaction to the underwriter's request for a letter of explanation was to argue that's it's not necessary you said. You might be thinking that you haven't written anything longer than an email since you left high school or college.
Why do you need a letter of explanation for a mortgage?
When the underwriter examines your loan application, the underwriter may need some context about an issue. The most common concerns that require an explanation are late payments on a credit report. Frequent job changes also draw an underwriter's attention. If the underwriter sees a large deposit on the bank statement, he or she needs to know where it came from. Large deposits are perceived as loans, unless proved otherwise. Underwriters want to approve loans, however, they need reassurance that you will not default on the loan. If an underwriter approves too many bad loans the underwriter may lose his or her job.
How to write a letter of explanation
If you can pen a letter of explanation, great. Keep it short and professional; be as specific as possible and include exact dates and dollar amounts. There are numerous examples of explanation letters on the internet. Just search "mortgage letters of explanation" and hundreds of templates will pop up. Here's an example of the structure for an explanation letter:
Letter of explanation mortgage example:
Lender city, state, and ZIP Code
Lender phone number
To whom it may concern:
I am available to answer any additional questions and look forward to our expected closing date of June 30.
Your mailing address
Your city, state, and ZIP Code
Your phone number
Provide any available documentation to support your explanation letter. If you have late payments on your credit card(s) due to a health reason, make copies of any bills to corroborate your letter of explanation.
Credit inquiries letter
Underwriters often ask the applicant to address any recent credit inquires. The reason is that any new credit account could affect the applicant's debt to income ratio or could be a used toward the purchase of the dwelling.
Here is an example of a credit inquiry letter:
I am writing to explain the following inquiries listed on my credit report:
[List the inquiries on the credit report; including the date of the inquiry]
Every one of these credit inquiries was for obtaining a competitive interest rate for a mortgage. No additional debt was incurred, and no new credit was offered from these inquiries.
Large deposit letter
A large deposit will draw the attention of the underwriter. The reason is that prospective home buyers are not allowed to use borrowed money for the down payment, closing costs or prepaid expenses.
Large deposit letter example:
I am writing to explain a bank deposit for the amount of _____, that was deposited into my checking (savings) account with _____Bank on May 2, 20XX. The deposited funds were obtained from the sale of my _____to _____on May 28, 20xx. I have enclosed a receipt for the sale of the _____.
Explanation for medical collections
Medical collections are not unusual. In fact, the new credit scoring model FICO 9, disregards all paid collection accounts. Medical debt is now treated differently than consumer debt by the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Federal Housing Administration (FHA). As a result, settled or paid collection accounts should have no effect on your credit score.
FHA does not take medical collections into consideration for loan approval and do not have to be paid off. The FHA does not include medical collections in the borrower's debt-to-income ratio. Even though medical collections are set aside from other outstanding debt, underwriters may require a letter of explanation. See an example letter of explanation here.