Letter of Explanation & Credit Issues

A letter of explanation provides a framework for past credit issues.

Credit issues are commonplace among potential homebuyers. Many homebuyers, especially those who have experienced past financial hardship, have collections, late payments, missed payments or even a bankruptcy or foreclosure on their credit report. While all mortgage loan programs have guidelines that lenders must follow, most loan programs offer some form of exception for those who have past credit problems possibly caused by circumstances beyond their control. A letter of explanation is part of exercising those exceptions.

Mortgages and Credit Issues

The whole purpose of loan guidelines and the underwriting process is to determine and ensure that a new homeowner has the will and the ability to repay his loan. Lenders use several indicators to determine this. One of these indicators is credit history. A person who has a record of financial responsibility and promptly repaying debt obligations is more likely to repay his mortgage than someone who does not. Negative credit issues on a credit report tell a lender that a potential borrower may not have the personal or financial responsibility necessary to handle a major debt, such as a mortgage payment.

Exceptions

Even the most financially responsible people encounter situations they cannot control and that cause them to experience severe financial hardship. The death of a primary breadwinner, a life-threatening illness or major bodily injury that hinders a breadwinner's ability to work are examples of this. Though there are other issues that lenders consider exceptional, each loan program has its own set of exceptions. One of the things most lenders require in order to consider an exception is a letter of explanation.

Letter of Explanation

A letter of explanation places the reason behind any past negative credit issues in context. While things in the far past, such as missed or late payments more than three or four years old, do not need a letter of explanation, issues such as a judgment, tax lien, bankruptcy or foreclosure in that period will. Each loan program has its own rules for how recent a negative credit event can be before an exception requires a letter of explanation. Supporting documentation must accompany all letters of explanation and the reason presented in the letter must make sense as well as fit the credit report. A good letter of explanation also spells out what has occurred that will prevent the negative situation from occurring again.

Program Guidelines

Conventional loan guidelines are much tougher regarding exceptions and what explanations they will accept. Government loans that use Department of Housing and Urban Development, or HUD, allow more leeway on the weight given to letters of explanation and attached documentation. HUD guidelines require a letter of explanation to accompany all past negative credit, even if there is no need for an exception.

references & resources