Your buyer’s loan application, credit issues and saving your fee: have the repentant buyer submit a letter explaining his derogatory credit history

This article analyzes the use and advantages of a derogatory credit explanation letter when derogatory items appear on a homebuyer’s credit report.

During this Great Recession, lenders are extremely cautious to lend and loan funding is scarce for everyone except those with perfect credit. The likelihood of a denied loan application has dramatically increased from the easy money days of 2006, and will only worsen through 2010 as the Federal Reserve (The Fed) withdraws excess funds from the financial markets and lenders begin repayment of the Troubled Asset Relief Plan (TARP) “loans” made by the Treasury.

While a lender’s refusal to lend vanquishes a homebuyer’s ability to obtain financing to purchase a home, it also blocks the transaction agent (TA) who represents that homebuyer from collecting a fee and earning an income on the sale he negotiated. Thus, it is in the interest of both the homebuyer and the TA to ensure all reasonable steps are taken to qualify the homebuyer for a mortgage.

Editor’s note – The initial step for the TA is to have a lender pre-approve the homebuyer, a preliminary activity we do not review here.

An unblemished credit report is rare. The credit reports of most would-be-homebuyers contain derogatory items negatively affecting their ability to obtain financing, such as:

  • defaults;
  • foreclosures; and
  • late or missed payments.

Loan officers employed by lenders presume derogatory items on a credit report indicate the homebuyer has an increased risk of defaulting. A poor credit report may indicate a homebuyer’s financial habits and propensity to repay debt were at one point inappropriate for the loan currently sought. It is in the professional interest of a loan officer not to approve a loan for a homebuyer that has an unacceptable risk of falling into default (especially in times of greater government scrutiny when so many loans are turning or have turned bad).

Thus, when derogatory items exist on a credit report or a verification by a lender, the prudent TA makes sure his homebuyer prepares and submits a Derogatory Credit Explanation Letter to the lender. The Derogatory Credit Explanation Letter is designed to provide a personalized explanation for the derogatory items listed on the credit report or verification request. This candid response to the credit report is considered favorably by lenders when determining creditworthiness, and often makes the difference between approval and funding or denial of a loan. [See first tuesday Form 217-1]

Consider a homebuyer who needs a loan to fund his purchase of a home. The homebuyer’s TA completes a form for tracking the loan origination process and reviews it with the homebuyer. The form itemizes the different steps in the loan origination process. The homebuyer begins the property acquisition process by selecting a lender to provide funding for the loan. [See first tuesday Form 339 §1.1]

The homebuyer meets with a loan officer and submits a loan application. The lender orders out and receives a credit report which is sent to the homebuyer with the mandatory notice of credit score usage, informing the homebuyer of:

  • the homebuyer’s credit score as calculated by the credit reporting bureau; and
  • the key factors from the credit report adversely affecting the homebuyer’s credit score. [See first tuesday Form 227]

The homebuyer advises the TA he received the credit report and the credit score notice from the lender, and that there are negative items which may affect approval of the loan. The TA advises the homebuyer to immediately complete a Derogatory Credit Explanation Letter and submit it to the lender. [See first tuesday Form 217-1]

For the homebuyer, the explanation letter contains a cover page with instructions and recommendations for drafting a persuasive letter. While the TA offers to provide help when filling it out, he does not prepare any part of the letter for the homebuyer since the letter must appear sincere and contain personal information written in the words of the homebuyer, conditions that only the homebuyer can provide.

In the body of the explanation letter, the homebuyer identifies each of the derogatory items listed on the credit report. In chronological order, the homebuyer notes:

  • the name of the creditor appearing on the report;
  • the date each item was added to the report; and
  • the total sum of money involved with the negative item. [See first tuesday Form 217-1 §3]

Next, the homebuyer enters his explanation for each of the derogatory items listed. The explanations must establish enough historical context surrounding the rise and resolution of the derogatory items to adequately express the factors which colluded to create it. The explanations given need to be focused, concise and not waver from the history surrounding the item. [See first tuesday Form 217-1 §4]

In this example, some of the derogatory items were the result of the homebuyer’s own negligence in handling his finances. In addressing his neglect in avoiding delinquencies, the homebuyer is honest about his mistakes and approaches the items from a perspective which exhibits his reformed financial habits. He itemizes the steps he has personally taken to correct the negative items marring his report. In his acknowledgment of mistakes, the homebuyer provides concrete examples of how his financial health has improved as the result of his more prudent money management and spending patterns.  [See first tuesday Form 217-1 §4]

The TA advises the homebuyer to submit supplementary information along with the explanation letter to provide support for his explanations. Some of the negative items on the report resulted from a job loss and a period of unemployment with no savings to draw on, so the homebuyer attaches a copy of his layoff notice and unemployment records. This additional information, together with having later established a savings account, lends legitimacy to the homebuyer’s explanation.

The TA instructs the homebuyer to mail the explanation promptly. Time is of the essence, as the explanation letter is ideally viewed by the lender concurrently with the credit report containing the derogatory items.

Does the lender provide funding for the homebuyer even though he has less-than-perfect credit resulting from derogatory items on his credit report?

Yes! The loan officer, reviewing the explanation letter and exercising human judgment, is now able to determine the homebuyer does not pose an unacceptable risk of default as first indicated by the credit report. The explanation letter establishes the context for the negative items and provides a medium for the homebuyer to persuasively express his awareness of the negative items and his eagerness to avoid similar problems in the future. Thus, the homebuyer is able to purchase the property he desires – enabling the TA to earn his fee.