Refinancing a mortgage takes sufficient equity and sometimes, a little explaining. Lenders require letters of explanation in a refinance transaction for a variety of reasons. Potential red flags, such as late payments, employment gaps, application discrepancies or recent credit inquiries, may require explanation. Lenders may need you to list plans for cash out refinance funds, as well.
Credit Scores Not the Only Concern
Negative information on your credit report may cause a lender to question your ability to repay the new loan you're acquiring in a refinance. Even if you meet the lender's minimum credit score requirement, you may need to clarify black marks on the report. For example, a mortgage lender may require you to explain 30-day late credit card payment or a bankruptcy discharged four years ago. Other items of concern that may require a letter include:
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- Child support arrears
- Court-ordered judgments
- Recent credit inquiries
- Past names, employers and addresses
A letter of explanation provides the lender with key points:
- Circumstances that led to credit mishaps, financial problems or discrepancies
- Measures taken to remedy the situation
- Changes that have occurred that will prevent it from happening again
This information helps the lender determine whether the issues are remedied or likely to re-occur and affect your ability to repay the refinance. You must sign and date the letter.
Application and Credit Report Discrepancies
A discrepancy, such as an address that doesn't match the current address on your refinance application, may require explaining. You must assure the lender that the home you refinance is your primary residence. Unscrupulous borrowers may try to refinance investment properties as primary residences to get better refinance terms and rates. Also, recent credit inquiries may indicate that you have more debt than is reflected on your application. A letter of explanation either confirms new debts and provides the new balances or reassures the lender you have not incurred new accounts. New debt affects debt-to-income ratios, or your debt load, potentially making the refinance riskier for a lender.
A Letter About Late Payments
A lender needs to know the reason you missed a payment to ensure it was an isolated incident and unlikely to re-occur after the refinance. Even if the number of missed payments, or the time since the missed payment, is acceptable to the lender, it still requires a detailed explanation. For example, you might explain how you forgot to make a payment while you were on vacation, hospitalized or otherwise unable to pay for 30 days on the account. You can also cite issues beyond your control, such as billing problems with the company that reported the late payment or identity theft or fraud. In such cases, where you were not directly at fault for a missed payment, you should provide evidence from the collector to support your claim. However, a letter is no substitute for bad credit or delinquent accounts that were the direct result of money mismanagement.
Income and Employment Explanation
A letter of explanation in a refinance may help confirm that your income is sufficient, steady and continuous. For example, salaried employees or wage earners who are missing pay stubs because of an absence from work may need to explain income and employment gaps. Lenders may accept an explanation that involves temporarily illness, a disability or legitimately being unable to work. However, the lender may deny the refinance if the gaps resulted from job loss, quitting or getting fired in the past two years.
Business owners, independent contractors and the self-employed may have to explain employment and income in the absence of pay stubs. Lenders use tax returns to calculate income, but may ask for a letter of explanation when income appears to have declined. The letter should explain the reduction in income and confirm that it has stabilized.
Cash Out Refinance Reasons
A refinance letter in a cash out transaction helps the lender determine whether funds will go toward a reasonable financial use. A cash out refinance results in cash back at closing. You take out part of your home's equity and borrow a balance larger than your previous mortgage. This increases the risk of default, as the mortgage payment increases and the home's equity decreases. Lenders have strict underwriting guidelines for cash out refinances and may require information about your plans for the money you receive at closing. Your letter includes viable reasons for cashing out, such as home improvements, paying off high-interest debt, medical bills or tuition. It's at the lender's discretion to decide whether the cash out proceeds will be used in an appropriate manner or whether you are likely to use the money to incur further debt, such as a second-home purchase.