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How prepaying your mortgage affects your credit score

Want a sense of accomplishment? Pay off your mortgage loan early. There's a certain thrill in sending off that last payment to your lender and knowing that you now officially own your home. There's even a prepayment calculator that allows you to make your mortgage any term you like by making simple fixed prepayments each month.

But don't expect your FICO credit score to jump just because you no longer face a monthly mortgage payment.

"Paying off your mortgage ahead of schedule will typically not help nor hurt your FICO score," says Anthony Sprauve, director of public relations with myFICO.com in San Jose. "The [FICO] scoring algorithm takes into account whether mortgage payments and other payments are made on time, and not whether the mortgage is paid ahead of schedule."

This surprises many homeowners who think that eliminating a monthly source of debt should boost their financial ability to pay other bills on time and cause their credit score to rise.

FICO doesn't factor in early payment

But it doesn't, says John Ulzheimer, president of the Ulzheimer Group in Atlanta and founder of CreditExpertWitness.com. Ulzheimer says it makes perfect sense that your FICO score would remain largely untouched after you pay off your mortgage loan. While it's true that paying off your mortgage frees up money that you can use to pay other debts, unfortunately, he says, your FICO score doesn't take that into account.

Mortgage debt does contribute -- often quite heavily -- to your debt-to-income (DTI) ratio, a measurement of how much of your gross monthly income your monthly debts consume. Mortgage lenders will study your DTI ratio when considering whether or not to lend you money, but again, "your credit score doesn't measure that," says Ulzheimer. "It measures whether you choose to pay your bills on time."

Paying off early might hurt

There are even times when paying off a mortgage loan early could hurt your credit score.

Homeowners who have no other installment loans -- such as a car loan -- could see their scores fall slightly because the credit bureaus like to see how consumers handle multiple forms of debt, such as installment loans and credit cards. Paying off your mortgage could mean you have one less active entry in your credit file.

Retiring debt early first requires a financial review

But just because paying off your mortgage loan early won't substantially increase your credit score doesn't mean that you shouldn't do it. Paying off your mortgage early can save you thousands of dollars in interest over the life of your loan.

"No one likes to be in debt," says Ulzheimer. "And you do pay interest on that loan. Someone else is profiting off your money instead of you. If you have the ability to comfortably pay off a bill, I suggest that you do so."

What you shouldn't do, though, is take money out of your retirement to pay off your mortgage early, says TJ Freeborn, a mortgage expert with Discover Home Loans in Chicago.

Freeborn says that homeowners should first examine their finances before deciding whether or not to pay off their mortgage loan early. It might make more sense, for instance, for you to eliminate your credit card debt before prepaying your mortgage loan. Credit card debt, after all, comes at much higher interest rates.

There can be a surprising range of things to consider before you prepay your mortgage. HSH's comprehensive Mortgage Prepayment Guide covers all the nuances, including the effects of different methods of making prepayments.

Prepayment penalties

You also need to consider any possible prepayment penalties before you decide to pay your mortgage off early. Some mortgage loans charge hefty penalties -- as much as 2 percent to 4 percent of a loan's outstanding value ($4,000 to $8,000 on a $200,000 mortgage) -- to homeowners who pay off their mortgage loans within a certain period of time, usually within three to five years.

Forget the mortgage interest deduction

Finally, Freeborn says you shouldn't worry about losing out on your mortgage interest deduction when paying off your mortgage early. Mortgage interest becomes less and less a factor, especially once you get to the point where you are able to pay off your loan a few months early. The longer you live in your home, the less interest you have to pay each month.

While you can save thousands of dollars in interest by paying off your mortgage early, it's important to understand that there probably won't be any great improvement to your credit score as a result.

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This article was revised by Keith Gumbinger.

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