In mortgage applications, a well-written credit explanation letter can be the deciding factor between approval and denial. By making the most of the opportunity to explain any negatives of their credit past and present, borrowers can positively impact their chances.
What is a credit explanation letter?
A credit letter of explanation is documentation provided by the borrower. At its most effective, it is formal, professional and to the point, addressing specific items on a credit report as singled out by the lender. Not every application gets as far as a request for a letter of explanation, and the receipt of this request should be considered a good sign. The fact that the borrower is being afforded the opportunity to explain past lapses or unusual circumstances indicates the application is being given serious consideration.
When do you need an explanation letter?
A broad range of circumstances might prompt a lending institution to request a credit explanation letter, including these scenarios:
- The borrower is self-employed. More detail on income may be needed.
- There are gaps in the borrower's employment history.
- The borrower's income has been declining.
- The borrower has recently changed jobs.
- The borrower has negative items on their credit report.
- The borrower has recently opened new credit cards.
- There are recent large deposits or withdrawals from the borrower's bank accounts.
- There are other people's names on the borrower's credit report.
- The borrower has a high debt-to-income ratio.
How do you write a credit explanation letter?
A credit explanation letter should be written succinctly and professionally while answering every item. This is not the time for vague statements about lessons learned or bad times encountered. That's not to say that information should not be included, but it must be in response to a specific question. Every credit explanation letter should include these elements:
- This happened.
- This was the negative result.
- This is how it was addressed.
- This is why the lender should rest assured it won't happen again.
There will most likely be no follow-up questions. The credit explanation letter is the only chance to move the application forward. Specificity, clarity and detail are all important.
Above all, honesty is essential. Lying or misrepresenting facts on a mortgage application is not only illegal, it is a sure way to get the loan application declined. Discovery of a misrepresentation after the fact can result in the bank raising the interest rate or calling the loan in full.
Sample of a credit letter of explanation
A credit explanation letter should begin with a salutation and end with a businesslike close. It should be typed on full-sized, white letter paper.
Here is a sample letter:
Borrower's town, state and ZIP code
Lender's town, state and ZIP code
Re: Borrower's name, loan application number, your letter (email, phone call) dated ___ requesting information
I am writing to explain the large deposit of $15,000 to my bank account on September 3, 2019. I was awarded the money as first prize at an art competition. The congratulatory letter from the awards committee is included with this letter.
In regard to the one derogatory item on my credit report for a late car payment, I was injured in a car accident two years ago and out of work for three months. Despite my efforts to pay all of my bills on time, I was unable to prevent one from going overdue. That bill has since been paid. I have attached a copy of the online payment that I made only 15 days late. I have also included the latest statement from the car loan company showing that I am paid in full. I have also attached a letter from my employer stating the dates I was out of work and that I am back full time. My employer was also nice enough to add a handwritten note indicating that they value me as an employee and expect me to be with them for a long while.
I hope this information addresses (the lending institution)'s concerns.
Borrower's name as it appears on the loan application
Borrower's phone number
Borrower's email address
The letter does not have to be perfect. It should show a human element while demonstrating respect for the process.
Frequently asked questions about credit scores
How can I see my credit report?
The law requires the three major credit bureaus – Equifax, Experian and TransUnion – to provide a free credit report once every 12 months. Borrowers should take advantage of this opportunity to examine the information that will be passed on to lending institutions.
The safest way to obtain these reports (borrowers should request all three) is through AnnualCreditReport.com, the only site authorized by federal law. Users should make sure they are on the correct site, because sensitive information that must be kept out of the wrong hands (like Social Security numbers) will be requested.
Can you remove hard inquiries from your credit report?
Assuming they are not the result of an error, hard inquiries cannot be removed from a credit report. A hard inquiry is the result of a request for a new line of credit, like a mortgage or a new credit card.
While hard inquiries do have a negative impact on a credit score (since they represent an actual request for more debt), the effect should not be overly concerning. Hard inquiries contribute only 10% of the overall score, and while they will remain on a credit report for two years, they only figure into the credit score calculation for one year.
Can disputing your credit reports hurt your credit scores?
Sometimes mistakes are made and inaccurate, damaging information shows up on a credit report. Disputing these errors will not negatively influence a credit score. What disputes will do is temporarily take the information out of the calculation altogether, preventing people from gaming the system.
The potential downside is not to the credit score, but to the entire loan process. Many lenders will not allow a loan to go to closing if items on the credit report are flagged as being under investigation.
Tips for loan officers to write a better FHA credit explanation letter
Since the 2008 financial crisis, mortgages that might once have been easily approved are given additional scrutiny. Even when a loan officer helps craft an FHA credit explanation letter, it can be more difficult to secure approval in the post-Great Recession world.
That is not necessarily a bad thing, as many subprime mortgages were issued back then and resulted in the housing bubble that started it all. However, if you are a responsible loan officer working with a borrower who truly deserves a loan, there are some steps you can take to make sure your credit explanation letter is ironclad.
1. As a loan officer, you should let the borrower put it in their own words.
A perfect letter put together completely by the loan officer can easily be detected by the underwriter and will hold less weight when they see it. Allow the borrower's own words and personality to make their way into the letter.
2. Don't leave the borrower completely on their own to write the letter.
Most loan officers still simply give the borrower a list of derogatory accounts and ask them to explain them. Don't do that. Give your borrower the proper guidance. Tell them what you expect from them.
Sadly, the average high school graduate today is functionally illiterate when it comes to the task of putting together such a letter. You do good people a disservice when you leave it all up to them. They could probably do a fine job of explaining it themselves if they were speaking directly to the underwriter and the underwriter could ask follow-up questions. That doesn't happen anymore, so you must help them get it right from the beginning.
After the borrower explains the details of the situation that caused the credit problems and you have informed them that it is a crime to lie in this instance, have them write out exactly why the problem happened. Make sure they address and account for every single negative item on the credit report, no matter how old or how insignificant it appears. Get them to explain in their own words why they feel this problem won't happen again and exactly what they have changed in their life to prevent it. Then have them explain why they feel the underwriter can reasonably expect them to be able to make the payments.
Don't skip any of those points. Once the borrower understands what is needed, let them put it in their words.
Many loan officers tell their borrowers to keep their explanation letter short. Don't fall into this trap. Make sure the borrower explains everything in tedious detail, to the point that anyone who picks up that loan file 10 years from now would easily understand why this borrower ended up being approved.
Here's a bonus tip: To satisfy the underwriters who don't like to read, always include your own cover letter in the submission file, briefly summarizing the borrower's credit explanation and adding your own interpretation of which compensating factors the underwriter should consider.
When you structure the explanation part of your file this way, you help the underwriters make the decision without having to figure out on their own how they are going to justify it. This makes them more comfortable giving you an approval with fewer conditions.
3. Document the borrower's credit explanation and solution.
This is the extra punch even experienced loan officers often leave out, but it is the step that can take you above the level of the average loan officer into the category of miracle worker in the eyes of your borrower and their real estate agents.
Get some documentation to prove the borrower's credit explanation and their claims of how they have changed things are true. This involves extra work for you and for the borrower, but it's worth it. If the borrower had a medical problem, get a note from their doctor, or include their medical bills in the file. If the borrower was laid off, include a copy of their termination letter or evidence of their receipt of unemployment benefits. If the borrower said their problems occurred because they had no medical insurance, prove they have it now. You get the idea.
Of course, borrowers often have difficulty finding this type of documentation. That's why the average loan officer never gets it. Push them. It doesn't take much documentation to add considerable punch to your case that the loan should be approved.
When loan officers complain about rejected applications that should have been approved, the common element in almost all of these cases is that the loan officer left it up to the underwriter to figure out why the loan should be approved. To avoid extra work that might go to waste, loan officers often submit a loan without the proper documentation, hoping it will slip through. Underwriters don't have time for this. When you put them in this position, their answer will be to turn down the loan – or approve it with something like 4,000 conditions of approval.
Expertise is key in the modern mortgage industry
Times are difficult in the mortgage industry. The mortgage originators who survive will be those who find a way to help the people other originators aren't helping. Becoming an expert on FHA loans can be the best way for a loan officer to do that. Use these tips to get more loans approved and get more referrals from your happy customers.
Suffice it to say that writing a credit explanation letter is not a task you can undertake on the fly. Getting it right requires time, attention to detail and the gathering of supporting documentation. A well-constructed letter will not only address a lender's questions but give the borrower the satisfaction of knowing they did everything possible to help their cause.
Carl Pruitt contributed to the writing in this article.