Letters of Explanation

Letters of Explanation or “LOEs” as they’re known in the business (mortgage lending, like the military, has an acronym for just about everything) are written to account for or explicate some variance that may not be apparent to the lender’s underwriter.  Their purpose is to expeditiously facilitate the underwriting and approval process.  A request for a letter of explanation is usually made when something is seen by the underwriter that warrants the clarification of an issue.  The most commonly written letters of explanation revolve around explaining minor derogatory or detrimental consumer credit issues, for example late payments on credit cards or installment loans, including student loans.  Occasionally, a mortgage broker will draft one to point out compensating factors when requesting an exception to normal underwriting guidelines.

THE UNREAD LOE

The most under-utilized and unread LOE is the cover letter written by a mortgage broker accompanying the loan file.  A good cover letter briefly details essentials such as the LTV, the borrower(s) FICO scores, while simultaneously answering questions.  Is the proposed loan a refinance or a purchase?  Is it a rate and term (refi) or is there is cash out involved?  Is it a full-doc loan or a stated income one?  Is the desired loan program a conventional loan, an FHA, a VA or something else?  The inclusion of a cover letter also bespeaks a certain care and organization that is often sadly lacking with loan submissions.  Not surprisingly, sloppy files get kicked back to mortgage brokers or loan officers and/or go to the bottom of the underwriting pile and it is also a major reason why loans do not close more quickly.  A few (but very few) brokers and loan officers do routinely write cover letters and include them when submitting a loan for processing and underwriting.  (The reason that most mortgage brokers have dispensed with writing cover letters is because underwriters or loan coordinators (underwriters’ assistants) never bother to read them or simply tear into a file and scatter its carefully packaged contents among various loan personnel and then request docs that were already included).  Equally important, is that if the broker is not clear on something or doesn’t know when a document will be forthcoming it is vital to inform lenders of this as well—no one appreciates being kept in the dark—particularly underwriters.

THE CONVENTIONAL LOE

As lenders have tightened their guidelines in the past 24 months there are more requests for explanatory letters than ever before.  Letters of explanation may be requested for a variety of reasons. What follows is an alphabetical arrangement of the most common examples of requests for Letters of Explanation and satisfactory supporting documentation.    

Bank Statements.  When using bank statements, be prepared to write a LOE for any unusually large deposits or other abnormalities with a particular statement like insufficient funds notices, etc.

Bank Statements (Paperless).  Some lenders will not accept on-line bank statements because of the relative ease of doctoring on-line statements.  Because more and more people are now banking on-line, this rule is being relaxed, somewhat.  Yet, some will still only accept bank statements with the bank’s log or letterhead clearly affixed to the statement. If that’s not available, one solution is to provide a Verification of Funds or Verification of Deposit.

Business Expenses.  Borrowers who own businesses owners and incur business related expenses that that show up on their credit reports in their own name should write letters of explanation showing that these expenses are reimbursed in order to have them removed from personal Debt to Income Ratio (DIR) calculations. Examples such as personally guaranteed company credit cards, car leases and loans can be supported by cancelled checks or payment receipts.  

Business Failure.  It is best illustrated with tax returns for the most recent year or proof that the borrower is no longer self employed (i.e. current pay stub from employer).

Cash Out (Purpose of).  In refinance transactions, you may be asked to explain your reasons for refinancing, the purpose of which is to pass a "benefit to the borrower test" required in many states, apparently to protect you from yourself. In these cases, a letter of explanation should prove a  net tangible benefit to you, the borrower.  Note: if you are asked to explain the purpose of increasing the loan amount for pulling cash out, it is crucial to recall what you may have stated on your 1003 (loan application) so as to  not contradict yourself.

Credit Adjustments.  Collections, multiple late payments, loss of income, or any major or sudden changes to your financial situation will require explanation and supporting documentation.  A LOE is generally mandatory if your credit history contains a bankruptcy, foreclosure or judgment.  Providing letters to creditors and credit bureaus in which a borrower has contested late payments or collections with creditors and credit bureaus are requisite.

Credit Inquiries (too many recent).  If your lender asks you about excessive inquiries for your credit report you may need to account for this.   For example, it may be as simple as citing that you were “shopping” for      a mortgage at that time.

Divorce.  Marital credit issues can be documented with a divorce decree or separation agreement, court ordered documents for child support, tax documents for the most recent year filing jointly, paperwork pertaining to arrearages in child support, and printouts from domestic relations court showing either satisfactory child payment history or arrearages.

Employment Gaps.  Lenders will sometimes require a letter of explanation if you have a period of unemployment in the recent past.  A simple LOE may account for gaps in employment.

Financing Is there a non-occupying co-borrower?  Typically, this is requested for FHAs where non-occupant co-borrowers are allowed.  A letter indicating one’s residency and/or relationship to the primary borrower is in most cases all that will be required.

Gift Funds.  A relative giving a gift to a homebuyer may be asked to write a letter of explaining the funds are for the purchase of a home and do not have to be paid back.

Injury (resulting in inability to work).  It can be shown with proof of Workman’s Compensation and letters from doctor or employer about the injury.

Job Loss.  Claims can be supported with layoff notice, Unemployment Office records, and other proofs of dismissal.

Nit-Picky, the.     Lately, no item appears to too small or inconsequential for underwriters to not request a formal LOE as lenders have become increasingly picky about the smallest inconsistencies.  Recently, I had an underwriter require an explanation as to why there was a variance between the phone number on an application and the one given to schedule the appraisal.  The answer was simply that the one on the application was the borrower’s home phone and the one given to the appraiser was his cell phone.  In       another instance, the borrower’s address on their April income tax returns differed from what was shown on their application dated in August.   The easy answer was that the borrowers had moved in July.  But in both cases, in addition to an LOE, it was necessary to provide cell phone and cable bills.

Property Issues.  Is there pending or outstanding litigation with the condo builder or the Home Owners Association.   A statement from either entity affirming that there is none should suffice.

Paper Trail (lack of a).  Sometimes a Letter of Explanation is necessary if there isn't a certain paper trail.  An example of this would be one where the buyer was using the sale of stock for the down payment, but that the funds hadn’t been transferred to the buyer’s bank account because the borrower had arranged for them to be wired directly to escrow.

Real Estate Owned or Additional Rent.  If you have multiple properties, and need to prove that one is your primary residence, a letter explaining that you reside at the property in question and spend more than half the year there, or otherwise meet the legal tests for residency, would be beneficial.

Spousal Abuse.  This can be documented with police reports, medical records, and Protection from Abuse orders from the court.

Trivial.  There are times when the underwriter’s request for a Letter of Explanation will be to explain something that may seem obvious.  For example: I have seen an underwriter ask for a Letter of Explanation to explain why the amount of the borrowers paycheck was slightly higher than the amount deposited in his bank account. While many people only deposit a portion of their paycheck into their bank account, and keep some pocket money, the underwriter felt more comfortable having the borrower explain this.       

Unusual, the.  On a purchase transaction where there is no realtor involved, it is common for an underwriter to ask for a Letter of Explanation regarding this. The letter is used to clarify the relationship between buyer and seller. If the two parties are related in some way, this needs to be disclosed to the lender.

CRAFTING A LETTER OF EXPLANATION

A carefully written LOE can go a long way toward getting a loan approved.  It is, however, not solely the province of the loan officer or mortgage broker:  After all who knows better what the situation is (was) than the actual party.  Depending on what the letter explains, it may also be written by a mortgage applicant's employer, family member, creditor, attorney, accountant, or the borrower themselves,

When I have asked borrowers to provide written explanations regarding some anomaly I have often been surprised by what I have received.  Some (from whom you would not expect it) have produced clear, concise, beautifully written missives, while other seemingly articulate people have dashed-off incomprehensible explanations.  As a result, I have had to re-write some letters on client’s behalves, making them more specific or logical.   With lenders’ guidelines having tightened considerably in recent years, I have been called on to draft more LOEs than ever before.    

The key to writing an effective letter of explanation is to understand what the underwriter wants to see.   If you are able to determine what the condition is that the underwriter is in doubt about you stand a much better chance of effectively composing a useful letter.  What most of them want is something that plausibly explains a situation, allowing them to approve a file.  If you are still in doubt what is being asked for or why, your mortgage broker, based on his or her experience, should be able to guide you.  

As important as understanding what an underwriter wants to see, is recognizing what they don’t want to see:  they want to see that you are putting the money to good use, and that more than anything else, you are NOT using this money to go out and get another loan.  The cardinal sin of borrowing is chaining debt.  Knowing this, you can write a good, honest letter of explanation, which should be short and to the point, and clear the "condition" for loan approval.

The letter should be as simple and short as possible; it needn’t be of essay length.  Often times a couple of well-thought out sentences will be sufficient explicate the matter.  Give the underwriter only what they need to know.  Some borrowers and Loan Officers (LOs) take the same approach that they did when they took essay exams and believed that sheer verbiage was a worthy substitute for quality and coherence.  It is still not so.

When composing an LOE keep in mind that this is your chance to make him/her understand one’s situation.  Personal entreaties rarely move underwriters (because if they approve loans that can’t be sold to investors, the lender has to portfolio the loan and it reduces the lender’s warehouse line of available credit—too many bad loans and the underwriter may be out of a job).  An underlying goal of the letter is to project responsibility and credit-worthiness.  What follows are a few simple things one might wish to observe. 

1. Be specific.  Cite the entry or inquiry first with the creditor’s name, account number(s), amount(s) and date(s). 

2. Explain the history of the problem, if warranted.   Don’t be timid about sharing the details of personal challenges.  Be honest about the circumstances that led to your financial problems. If circumstances were beyond your control, give a brief history of the events leading to you inability to meet your financial obligations. Life-impacting personal events and the emotions attached to them are important factors that an underwriter considers.  Remember, this letter is written for HUMAN eyes, not for a computer.  Also, be aware that your LOE will accompany the loan file to explain your circumstances to subsequent purchasers of the loan in the secondary market.   

 3.  If you were remiss in your obligations, i.e., the problems were due to your own negligence, be candid and admit your mistakes.  Follow this admission with a statement that you understand the importance of establishing a good credit profile and emphasize that you now place a priority on paying your bills on time. The LOE should stress to the lender the unlikelihood of future reoccurrences.

4. Describe the steps you took to correct the problem. “I paid the amount owed,” or “I entered into a payment arrangement” are good starters, especially if you can provide documentation for your claims.

5. Supply documentation to buttress your narrative.   When offering proof, make it verifiable:  including names, job titles, phone numbers, addresses. It is always advisable to have third-party documentation on company letterhead because of the relative ease in this age of cut and paste in “doctoring” letters. 

6. Close the letter with a summary paragraph or sentence that pulls it all together and describes a pattern of improved financial health.

In many cases, a well-prepared letter will yield a loan approval whereas lacking an LOE or a poorly written one, the mortgage application may be declined when it might have easily been otherwise.

Copyright © 2019 Rod Haase.  All rights reserved.