Credit Card Processing

Within the few seconds it usually takes for a credit card transaction to be approved or declined, several small steps are taken via an internet or phone line connection. Two main stages make up credit card processing: authorization and settlement.

Authorization

Card details and purchase amount must be first verified and authorized by the issuing bank. This happens in the few seconds it takes for a cardholder’s credit card to be approved or denied. The message often shows up on the card machine after a cardholder swipes or enters a card.

• Step 1: The cardholder swipes, taps or inserts their card into a merchant’s card machine to make a purchase. (Or enter a card number if purchasing online.)
• Step 2: The merchant’s credit card machine sends the card information and transaction details to the acquiring bank (or merchant bank) via the internet or phone line.
• Step 3: The acquiring bank receives the information and sends it along to the appropriate card network like Visa, Mastercard, Discover or American Express.
• Step 4: The card network routes the information to the cardholder’s issuing bank.
• Step 5: The issuing bank receives the information and checks the card details such as the card number and Card Verification Value (CVV) code to make sure the transaction is not fraudulent. The bank also ensures the cardholder is in good standing and has enough remaining credit to cover the purchase (or has sufficient funds to cover the transaction if using a debit card).
• Step 6: The issuer sends a response back via the card network to the acquiring bank.
• Step 7: The response is received at the merchant’s credit card machine or terminal. If all the credentials in Step 5 check out, the transaction will be approved. Otherwise, it will show a message like “denied” on the machine. The cardholder sees this information right away and finishes the transaction while the response code is stored on the merchant’s machine for stage two of processing.

This process may vary slightly depending on whether the transaction happens in-store or online. Traditionally, merchants set up a merchant account with an acquiring bank and link the point-of-sale system to an account. Merchants can set up accounts with merchant service companies like Square. Doing so removes the need for merchants to set up a direct relationship with an acquiring bank but adds another middle person to the equation.

Settlement

The second stage of credit card processing—settlement—happens among the merchant, acquiring bank, card network and issuing bank. This process involves much back and forth from party-to-party and includes the addition of processing fees charged to the merchant.

Each credit card authorization is stored in a merchant’s point-of-sale system. Typically at the end of the business day, a merchant sends a batch of authorizations to the acquiring bank. The acquiring bank will then confirm each authorization and send the batch via the card network to the appropriate issuing bank. The acquiring bank will also deposit the funds owed to the merchant into the merchant’s account, minus any processing fees.

The issuing bank pays the acquiring bank via the card network. Then, the card network debits the issuing bank for each transaction amount and credits the acquiring bank, essentially acting as a conduit between the two.

When a cardholder checks their spending activity via their online account, he or she may see a recent charge go from “pending” to “posted.” This usually takes one to three business days as the merchant settles sales with the other parties. The cardholder later pays the issuing bank what they owe for every purchase plus any fees or interest accrued as per the card agreement.

Related: Best Business Credit Cards

All credit card processing companies base their pricing structures on four primary fees. These include interchange fees, assessment fees, processor markup fees and monthly account or statement fees. Knowing what goes into credit card processing fees can help you understand your options and spot the best payment processing service for your business.

Interchange Fees

Interchange fees are set by Visa, Mastercard, Discover and other card brands. These are the unavoidable, base-level costs of processing credit cards. Often called wholesale or base fees, interchange fees generally range from 1% to 2% of the transaction amount. Payment processing companies collect interchange fees during the transaction process. They then transfer these funds to issuing banks as payment for the credit service.

Interchange rates vary greatly and depend on the merchant’s industry, the transaction type and the brand and type of card used. Here are a few examples of factors that impact interchange rates merchants pay to process credit cards.

• Transaction type: Card-not-present transactions, such as online sales, have higher interchange rates than in-store sales, where cards are physically swiped.
• Debit vs. credit card: Debit cards have lower interchange rates than credit cards because they are considered a lower credit risk.
• Card brand: Discover and American Express have higher interchange rates than Visa and Mastercard.
• Card type: Rewards, corporate and governmental purchasing cards have higher interchange rates than non-rewards cards since these programs cost the issuing banks more to administer.

Assessment Fees

Assessment fees, often called per-transaction fees, are also set by the card brands. These are flat per-transaction fees attached to interchange fees and typically range from 1 to 5 cents, based on the type of card and transaction.

As with interchange fees, assessment fees are collected by card processing companies during the transaction process. However, these fees are paid to the card associations, such as Visa, Mastercard, Discover and American Express, not to the issuing banks.

Processor Markup Fees

Markup fees are what credit card processing companies charge for their processing services. Markup fees vary based on the card company’s processing fee structure, such as a straightforward markup percentage called interchange-plus, complex tiered rates or simple flat-rate fees.

Each fee structure has benefits and drawbacks, which we explore in more detail below. Bottom line, markup costs vary greatly from processor to processor, so it’s essential to shop around for the best deal.

Monthly Fees

In addition to markup fees, many credit card processing companies charge monthly fees for specific services, such as statements, online gateways, PCI compliance and card terminals and other processing hardware. Some roll all of these services under a monthly account or subscription fee.

A few, such as Square, Stripe and PayPal, charge no monthly fees for credit card processing services. However, these providers typically have higher flat-rate processing fees that can cost more compared to processors that combine monthly fees with lower rates.

Other Costs To Consider

Some credit card processing companies have add-on and conditional fees that can affect your overall processing costs. To avoid surprises on your monthly statement, always check the fine print for add-on fees when comparing credit card processing companies.

• Chargeback fees: Unfortunately, chargebacks are an inevitable part of accepting credit cards and the cost of processing a chargeback varies greatly among processing services.
• Batch processing fees: Some tiered and traditional merchant services providers charge per-batch fees.
• Setup or termination fees: Card processing services with negotiated or tiered rate plans often require contracts with setup costs and hefty early termination fees.
• Monthly minimum fees: Some negotiated and tiered rate plan providers charge a monthly fee if contracted transaction volume minimums aren’t met.
• Same-day funding fees: Most card processing services deposit funds within one to two business days with no added fees but charge a fee for instant or same-day access to processed funds.

The most common payment processing models for small businesses include flat-rate fees, interchange-plus fees and tiered rates. Understanding the pros and cons of each is key to finding the best service and processing rates for your particular needs.

Flat-Rate Pricing

Flat-rate pricing is the simplest fee structure and typically charges one low rate for all credit card transactions, regardless of the type of card used. Many flat-rate processing services also provide free sales tools such as POS software, free card readers and integrated online gateways for e-commerce sales.

With flat-rate pricing, businesses pay one low rate based on the type of sale, with fees typically ranging from 2.5% plus 10 cents to 3.5% plus 30 cents per transaction. With flat-rate structures, in-person sales where the card is present have lower fees than online sales, but fees don’t vary based on card brands or rewards programs, plus you don’t have add-on fees for PCI compliance or monthly statements.

Flat-rate pricing can be a good option for businesses with low average transaction amounts, especially when considering free perks such as POS systems, online gateways and card readers. However, higher-volume sellers can save on credit card processing costs with interchange-plus or tiered pricing.

Interchange-Plus Pricing

Interchange-plus pricing is growing in popularity, mainly thanks to the small business-friendly plans offered by Helcim, Payment Depot and Stax.

Interchange-plus payment providers add a minimal fee to the base interchange rates set by the card associations.

Some, such as Helcim, mark up the interchange rate with a small percentage and per-transaction fee but have no monthly fees. Markup fees can range from 0.10% plus 5 cents to 0.50% plus 25 cents per transaction, based on the sale type. Others, such as Payment Depot and Stax, don’t mark up the interchange rate. Instead, they pair a monthly subscription fee with a minimal per-transaction fee, ranging from 5 cents to 15 cents per charge.

When comparing providers, remember that markup rates are in addition to the base interchange rates, which vary based on transaction-specific factors. Even so, interchange-plus models are very transparent and often the most economical choice for businesses processing more than $10,000 in monthly card transactions.

Tiered Pricing

Tiered pricing is a standard pricing structure used by traditional merchant services account providers and business banking services. To set tiered plan rates, providers first audit your business model and transaction history, so it takes more work to get this type of plan in place. Most tiered plans also require lengthy contracts and charge early termination fees if you want to change plans or providers.

Tiered plans break card processing rates into three groups, which are called qualified, mid-qualified and non-qualified tiers. Each tier’s rates are based on a merchant’s overall processing volume, industry and typical transaction types, such as online or in-person sales.
Each sale’s tier is determined based on the transaction type, credit card used and whether or not the cardholder’s billing address is verified. In most cases, qualified transactions have the lowest rates, while non-qualified transactions have the highest rates.

Tiered rates can be tricky to understand and the monthly statements can be very detailed. For most small businesses, flat-rate or interchange-plus plans are more economical and easier to manage. However, higher-volume businesses in certain industries, such as wholesalers and multi-store retail outlets, can save with a tiered card processing model.

Credit card processing fees are unavoidable, but there are several ways to minimize their impact on your bottom line.

Know Your Effective Rate

Figuring out your average card processing rate, called the “effective rate,” is a quick way to see if you’re spending too much on card processing. It’s a simple formula that divides total card processing fees by total card sales for a given period of time.

For example, if your monthly processing fees are $98.25 for $3,275 in total card sales, your effective rate is 3% (98.25 / 3275 = 0.0299 = 3%).

However, it’s essential to include monthly fees, statement fees and add-on costs that your provider charges in your total processing cost. If your processing service charges $39 per month, your total processing cost is $137.25 ($98.25 + $39).

After plugging the total monthly cost into the formula, the effective rate is a whopping 4.2%.

In this case, a flat-rate processing service with no monthly fees such as Square, which charges 2.6% plus 10 cents to 3.5% plus 15 cents per transaction, might be the better deal.

Negotiate Card Processing Rates

Don’t be afraid to audit and negotiate your rates with your processor every year or so, especially if you have a tiered plan. If your processing volume is higher than before, or if you’ve expanded into more in-person sales channels, you’re ready to negotiate lower rates.

Review Your Statement

Review every line item on your monthly statement and ask your processing service for answers or clarification if something is unclear. Interchange-plus and tiered statements can be complex. Take the time to review the processing charges and added fees, and use the effective rate formula to know the average rate you pay each month and for each sale type or processing tier.

Reduce Fraudulent Charges

Higher security risks equal higher processing fees. You can reduce fraudulent charges and chargebacks by upping your security with address verification for online sales and ID checks and signature-required receipts for in-person sales.

Consider Zero-Fee Processors

A few card processing companies add the processing fee to the sale total, so the customer pays the processing fee, not the merchant. This upcharge is generally called a “convenience fee,” and this processing model does away with your processing costs. Statistics show this works well in retail settings, especially when paired with a cash discount option.