Federal Housing Administration (FHA) loans are “Story Loans” … and the better you are at painting the picture for the underwriter, the more FHA loans you will close. The FHA was created in 1934, on the heels of the Great Depression, in order to help Americans achieve homeownership. Given the challenges they faced at that time in history, these loans had a lot of stories to tell. Today, we certainly have no lack of such stories in the loans we work on. How many times have you had this experience: You’re speaking to a potential client; everything about the loan sounds great, and you’re already adding up your commission when they pipe up, “Oh! Did I tell you I had a bankruptcy?” or “Oh! Did I tell you that I’m on medical leave?” The fearless and experienced FHA originator, undeterred by these statements, just gets out their FHA Intuition Palette and begins to paint.
As a former FHA underwriter, the Letter of Explanation, or LOX or LOE as some call them, is the single most important document in a borderline file. The LOX (what we call them here in the great state of Michigan), is the document underwriters turn to when they are undecided on a loan. And I can tell you that in my nearly 14 years of originating and teaching FHA, sad to say most LOs do not know how to help borrowers construct an effective LOX.
I have developed an LOX formula that I have used myself, and taught for many years, and it works! The formula is this:
The opening of the letter should give the background, the material facts and events that led up to the bankruptcy, such as the judgment, the repossession, etc. Be sure to frame the situation clearly for the underwriter. The body of the letter should convey the client’s struggle and their reaction; that is, what they had to go through in dealing with the challenge and how they reacted. This section is most critical and should contain what I call the “emotional hook;” that is, the life event that would make any compassionate human being feel sympathetic toward the person for what they experienced. It’s the challenge in your client’s life that makes the underwriter say, “Wow, they went through a lot.” If the letter you construct with your client can evoke this response in the underwriter, you’ve accomplished your goal. The closing should include a request to approve their loan and give them a chance. This is “where it’s at” with borderline FHA deals and is the reason that the FHA was created: To hear people’s struggles, stories and triumphs and to offer them the opportunity of homeownership.
Now, your clients won’t always have a compelling reason why they had problems with their credit, and often, the more borderline the deal, the less compelling reason they had for the mishap. Hence, the less likely the loan will be approved. Of course, that works in the other direction as well: The more borderline the deal and the more compelling the circumstances, the more likely the deal will get approved.
Now for an example of a well-constructed LOX:
My name is Derrick Johnson, and I wish to explain to you why I had a string of 30-day late payments on my mortgage and credit cards nearly two years ago. I was at work and sustained an injury to my arm that put me out of work for nearly six months. It was during this time that I fell behind on my bills, since I was not able to work. Before and after this time, as you can see from my credit report, I have a good history of paying my bills on time.
I suffered a lot of pain during this time, and in addition to being out of work, it was physically difficult to do the most basic things for myself. It took me nearly 30 min. to get dressed, and just feeding myself became a great task. Adding to the pain I was already experiencing were all the rude representatives from my creditors, who didn’t really care about the struggles I was going through. The pain of not being able to pay my bills only made my physical pain worse. Honestly, it was one of the most difficult times in my life.
Though many people in this situation might just ignore their creditors, I didn’t. Even though they didn’t seem particularly concerned with me or my situation, I made a point of keeping in touch with them throughout my time off, and gave them updates on my progress. I wanted them to know that I was creditworthy and that I wasn’t just ignoring them.
Although my credit still isn’t perfect, I take paying my bills seriously and have done the best I can. I am trying to buy a better home for my family, in a safer neighborhood with a better school system. Please know that it would make a huge difference in our lives if you would approve our loan. I sincerely request that you see the merit in my circumstance and give us a chance and getting our kids into a better environment and to achieve our dream. I thank you for your consideration.
This letter has every element of a good LOX. Without it, this type of loan can easily get denied.
I cannot tell you how many loan officers (LOs) either make up LOXs because they know they need them for the file, or don’t take them seriously. These LOs are making a big mistake, and will never become FHA experts. If need be, provide supporting documentation to back up what was stated in the LOX. By doing this, an underwriter feels more confident in approving a borderline loan.
The members of my FHA Success Desk online training resource have the benefit of asking us directly how to package their tough files before they submit them to underwriting. Recently, a member from California submitted a question about how to submit a file for a borrower who did jail time. Here’s the response I gave our member:
An underwriter’s concern here would not be whether he did jail time, but rather the length of time back on the job and whether it is considered stable income. FHA guidelines do not bar FHA financing to people who have been in jail unless it was for fraud-related to a housing or finance issue like giving or receiving kickbacks. Outside of housing fraud, once a person has served their sentence they are to be treated fairly as anyone else applying for a loan.
Here's the approach I would take:
1. Compose a good letter of explanation for the time he was off work. It should be clearly conveyed how remorseful he is and what a lesson he learned (if indeed he feels this way), but don't take more than a paragraph on this.
2. Connect his prior work experience to the current job and include letters from past employers for the VOEs if possible. If you cannot make this connection, then provide a resume.
3. Regarding the fact he has a fiancée; this will help the file tremendously and will likely be the thing that gets him approved in my opinion. It sounds like he's got his act together and wants to lead a productive life. Taking on marital obligations is a plus and adds stability to the file. So at the end of the LOX, conclude with a paragraph about how much they want to get approved for this loan in order for them to begin building a family together.
Remember, on a borderline file, the underwriter goes straight to the LOX hoping to find a good explanation for the derogatory information on their credit report. Now that you have the LOX formula, you can give the underwriter what they seek and you hopefully will be able to close more borderline FHA loans.
Jeff Mifsud founded Southfield, Mich.-based Mortgage Seminars LLC in 2004, has been an FHA originator for 12 years, is a contributor to LoanToolbox.com and is a former FHA underwriter. Jeff may be reached at (877) 342-9100.