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The Lowdown on Your Credit Rating

Thanks to the Internet, consumer pressure, and even government regulation, your credit report -- a formerly obscure and murky aspect of personal finance -- is becoming more transparent, accessible, and increasingly manageable.

You can already obtain a credit report online with just a few mouse clicks, and by the end of this month, you'll also be able to obtain your formerly elusive "FICO score." What's that? As explained in an article by Fool Paul Commins last August, it's the three-digit number, ranging from 300 to 900, assigned to your credit based on a formula developed by Fair, Isaac & Co.(NYSE: FIC), a small company with the vast majority of the credit scoring business. Your FICO score is usually calculated by credit reporting agencies based on your credit history, which they compile.

Fair, Isaac long sought to keep FICO scores secret, as well as the methodology behind them. Now, however, they are preparing to make the scores public, along with additional information on how your score was calculated. This will make it easier to determine which steps to take to improve your credit. Previously, you had to make some educated guesses as to what to do (though some steps, such as "pay your bills on time," were kind of obvious).

As a result, managing your credit is much easier, and can be as much a part of your personal finances as keeping track of your checking account, debts, and investments.

Why bother?
Certainly, it's not imperative that you know what your credit report looks like this very minute. However, if you're planning on buying a home or a car or any other major purchase soon, or if you're just curious, checking your credit history is worth the few minutes (and the few bucks) it takes. Even if a major purchase is a year or two away, checking your credit well ahead of time will give you the opportunity to correct any errors that may exist, or take steps to improve your score. Mistakes are not rare: A representative from Debt Counselors of America, now called MyVesta.org, told SmartMoney not long ago that as much as 30% of credit reports include inaccuracies.

In addition, your credit score will significantly affect your ability to obtain loans and mortgages, and will likely affect the interest rate you pay. According to Fair, Isaac, the FICO score is used in 75% of residential mortgage applications. Moreover, use of FICO scores has increased in recent years as automated loan approvals have become more common among lenders. According to a recent U.S. News & World Report article, E-Loan(Nasdaq: EELN), an online lender that has fought with Fair, Isaac over making FICO scores public, found that for auto loans, consumers with FICO scores of 720 or higher were likely to receive interest rates up to four percentage points lower than those with scores under 640.

Credit reports, credit scores
To be precise, a credit report is different from a credit score. Specifically, a credit report is a summary of various accounts, past and present, opened in your name, including credit cards, bank credit lines, mortgages, department store charge cards, and other bills, though usually not rent payments or utilities. A report will also include any collection actions taken against you, and any public-record information that may exist, such as liens or bankruptcy proceedings.

This information has always been available, though in the past you might have had to call a credit bureau's 1-800 number and then mail in a check. These days you can purchase this information online (more on this later).

In addition to your credit report, there's your credit score. When you apply for a loan through a mortgage bank or other lender, they request your credit report from one of the three major credit reporting agencies (CRAs), who then calculate your FICO score based on Fair, Isaac's model. Since your credit report might differ among the different CRAs, your FICO scores might differ as well. If you're not happy with one score, it may be worth getting a second opinion.

What's changing
In response to increasing pressure from consumers, and some lenders such as E-Loan (not to mention a California law scheduled to go into effect on July 1), Fair, Isaac struck a deal earlier this year with Equifax(NYSE: EFX) to provide FICO scores online, for a fee.

In addition, the two companies will provide additional information about where you stand compared to everyone else, and the factors that led to your score. According to a sample posted on Fair, Isaac's website, you'll see your percentile (what percentage of the population has lower credit scores than you) and the distribution of scores (what percentage of the population falls in each range of scores). In addition, the reports will likely include four "reason codes," as Fair, Isaac calls them, which are "the top four reasons your score was not higher." For example, having excessive balances on credit cards -- particularly relative to a card's credit limit (in other words, don't "max out") -- or having balances on too many accounts.

Fair, Isaac has also posted an explanation of all the factors they consider when formulating your score, and how much weight they're given (to get there from the main page, click on "Questions on Credit Scores? See our new guide," then click on "What a FICO Score Considers," on the left side of the page). For example, about 35% of your FICO score is based on, unsurprisingly, your history of repaying loans.

What you can do now
While FICO scores themselves won't be available for a few more weeks, you can still quickly obtain your credit report, and in some cases get a score similar to the FICO.

If you're interested in checking out your credit history, there are a variety of places to go. The big three CRAs are Experian, Equifax, and TransUnion. All offer credit report purchases online, usually for around $10. (Keep in mind that if you've been denied credit by a lender, under most circumstances you should be able to obtain a copy of your credit report for free.) While Equifax will be working with Fair, Isaac to provide FICO scores, the other two agencies are planning to offer their own scores by late summer, as well as information about the scores and how you can improve your rating.

Managing your credit
All this makes it much easier for you to stay on top of your credit. Not only can you correct errors or take steps to improve your record, but you can also add comments to your report to explain your side of any disputes or other problems that resulted in negative factors on your credit report.

For more information about credit scoring, including ways to improve your record, be sure to check out A Fool's Guide to Credit Scoring. Fool on!


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