What is a Letter of Explanation for Mortgages?

From general financial documentation to credit reports and debt-to-income (DTI) ratios, there is a lot of paperwork involved in the mortgage application process. And in some cases, your lender may ask for added paperwork and information, such as a letter of explanation (LOE).

While it is an important document, LOEs are not always a required piece of the home loan lending puzzle. However, depending on your financial situation, it can make a big difference in an underwriter’s final approval decision. That is why we are explaining what you need to know about mortgage letters of explanation, so you can be better prepared to provide one if asked during the underwriting process.

What is a letter of explanation?

A letter of explanation (or LOE) is your opportunity to give your lender added insight into your financial history and ability to repay your mortgage. Let us say you have a missed payment on your credit report due to a medical emergency, or there is a lapse in income from years past. The letter of explanation allows borrowers the chance to explain their finances in greater detail and provide more insight beyond what the numbers show.

Why would you need to write a mortgage letter of explanation?

Letters of explanation are not a required mortgage application document, but you will need to provide one if your lender requests it. However, it can never hurt to be proactive and include a LOE when you initially apply, especially if you are already aware of past situations that may throw up red flags or require added explaining.

Here are a few different scenarios in which a letter of explanation is warranted:

Credit issues

Your credit report reflects your history of making on-time payments for lines of credit or debt repayment. Once your mortgage application moves into the underwriting process, your lender conducts a hard inquiry to look for red flags. These include late payments, payment defaults, or bankruptcies. In these situations, it is helpful to include a LOE that details why any discrepancies in your credit report occurred along with assurance that it is not likely to happen again.

Employment gaps

Lenders may also require an explanation for any past lapses in income or employment history. That is why you will be required to provide a W-2 and paystubs with your mortgage application. They want to ensure that you have a consistent, reliable income source as proof that you will be able to keep up with your monthly mortgage payments. If you were unemployed or had no income for more than a month during the last few years, your lender may require a written explanation that details the reasons for the lapse, including:

• Childbirth or full-time parenting at home

• Caring for an ill family member

• Pursuit of further education

• A layoff

• Self-employment or seasonal jobs

Address discrepancies

In a situation where one of your documents shows a different address than what is listed in other paperwork, you will need to provide your lender with an explanation for the discrepancy. This is to prevent identity theft.

Large deposits

Lenders question any large deposits on your bank statements that are 50% or more of your total monthly qualifying income (some exceptions apply to certain loan types.) This is to ensure you have not opened any new debt that is not reporting on your credit and to confirm the funds came from a legitimate source. You will not only need to provide your lender with an explanation for what the large deposit was for but will also need to document the large deposit itself. This may include any of the following depending on your situation:

• Additional bank statements to verify transfers

• A copy of the check that was deposited

• A bill of sale if the deposit was from the sale of an asset

• A copy of the executed closing disclosure if the deposit was from the sale of property

• Loan documentation if the deposit was from newly opened credit

• A copy of the will or trust and final distribution decree if the deposit was from an inheritance

Gift money

Gift money, a common method of securing money for a down payment, can come from family members who have offered to help you cover a portion or all of the expenses. In most cases, a gift can cover both the closing costs and down payment, but there are certain restrictions based on the loan and transaction type (usually multi-unit, second home, or investment property transactions.)  Always check with your lender to see if you are required to contribute a minimum amount of your own funds into the transaction. If you receive gift money, your lender will need to source the gift funds with a copy of the gift check or donor’s bank statement and likely give you a gift letter to execute. This gift letter will typically ask for the following information:

• Exact dollar amount gifted

• Donor’s name, address and phone number

• Donor relationship with buyer

• Date of gift fund transfer

• Statement that no repayment is expected

• Property address

• Gift money recipient and donor’s signatures

How do you write a letter of explanation?

In the event that your lender asks for a LOE, it is likely they will provide the exact reason or discrepancy within their request. However, it is important to get it right and double check your letter prior to submitting it.

A letter of explanation will typically include the same details as other types of business letters, regardless of whether you are mailing a physical copy or sending it digitally.

Format for a letter of explanation

Here is a sample of what you will need to include in your LOE:

Date

RE: Your name and application number

Summary statement identifying it as a letter of explanation and reason for it.

Relevant details including discrepancy dates, exact dollar amounts, and the account information, (be sure to include attachments with any paperwork that confirms this).

Information regarding a spouse or co-borrower (if you have one).

A closing statement detailing your availability to answer additional questions.

Regards,

The goal of this letter is to provide an explanation that will satisfy your lender’s inquiry, just try to ensure that your LOE sticks to the point. One page will typically suffice.

It is crucial to be honest and concise in your explanation. While details are important, it is best practice to stick to the facts and approach the letter with a formal, professional tone.

What happens if your letter of explanation is rejected?

There are cases in which an LOE is rejected, but it is important to stay calm and not give up. You do have more options at your disposal, such as:

• Reviewing the letter for missing information and writing a new one to further explain or add additional details

• Choosing a different lender and applying for a home loan with them

• Taking time to resolve any financial issues, then reapplying

It is important to remember that lenders are essentially investing in your ability to repay a home loan when they decide to approve you for funding. That is why it is recommended that you take the time to ensure you are in the best possible financial position before applying.

At the end of the day, a past discrepancy or mistake may not halt your dreams of homeownership. Everyone has their own history and financial record, so it is important to take your time to thoroughly detail any requested explanations as well as research potential lenders and choose one who will work with you to accomplish your homebuying goals.