We’re becoming a cashless society. And, depending on which study you look at, people seem to prefer to pay with a credit card than with a debit card. As a business owner, this means you’ll have to take credit card payments just to survive. But taking credit card payments can get expensive and eat into your profits. What is more, the way the industry works is unusual. They use a lot of jargon too. So, we think it’ll be helpful if you have a general understanding of the mechanics of how credit card processing works. This way, you’ll at least understand why you’re being charged for this and that.
Let’s start with some vocabulary. We’ll end this article with a simplified workflow, describing how credit card processing works when no issues arise. We’ll save the more complicated workflow that includes how you deal with refunds and chargebacks for part two of our series.
What is an Issuing Bank?
For anyone who has a credit card, the issuing bank is the bank that sent you the credit card and the bank that you pay your monthly credit card bill to. The issuing bank is one of the most important players in how credit card processing works. You might have a checking or savings account at your issuing bank, but you don’t have to.
Note for debit cards, the issuing bank is the bank where you have the bank account associated with the debit card. Same term, slightly different meaning.
How Issuing Banks Work with Credit Card Holders
With Visa and Mastercard, the issuing bank can be almost any bank. So, your Visa card can be issued by Chase. Your Mastercard can be issued by Bank of America.
But American Express and Discover cards work differently. They are their own issuing banks. You can get a Discover card only from Discover, and you can get an American Express card only from American Express (there are small exceptions here and there, for AmEx).
Before the issuing bank gives you a credit card, it checks your credit worthiness. If the card is a personal card, then the bank checks your personal credit history. If the card is a business card, then it checks your business’s credit history. But, if your business is too new, then the bank might check the business owner(s)’s personal credit history too.
A credit card is basically a revolving line of credit—i.e. a standing loan from the issuing bank to you for x dollars. You can use the loan to buy anything you want, but you have to pay the bank back within a specified time or pay interest on the loan. Once you reach the x dollar amount of the standing loan, you don’t get more money until you pay down some of that loan.
If something goes wrong—for example, someone stole your card number or you want your money back on a credit card charge and the merchant is being unhelpful—you, the cardholder, work with the issuing bank to fix the problem. So, basically, cardholders only deal with issuing banks. Merchants who take credit cards, however, deal with a lot more entities.
Where Issuing Banks Fit into How Credit Card Processing Works
When a credit card user pays for something, the credit card information is sent through a computer network to the issuing bank. The issuing bank makes sure you haven’t exceeded your credit limit.
If the issuing bank clears you for the purchase and there are no other issues (e.g. signs of fraud), then the merchant can complete the sale. A few days later, the issuing bank pays the purchase amount to the merchant.
If there are no returns or other issues, the merchant gets to keep the money from the issuing bank.
What is a Credit Card Network or Credit Card Association?
Credit card network and credit card association mean the same thing. The credit card network is what people often think of as the credit card company. In the US, this means Visa, Mastercard, American Express, Discover, etc. In China, this mostly means UnionPay. JCB is popular in Japan, as RuPay is popular in India.
A Credit Card Network is Made of both a Group of Banks and Merchants and a Computer Network
The word network in credit card network is somewhat ambiguous. It means both a group of banks and merchants that take the particular brand of credit card. It also means a computer network that links these banks and merchants together.
Every credit card company runs its own network. That is to say, Visa has its own group of merchants that take Visa cards. Mastercard has its own group of merchants that take Mastercard cards. Merchants don’t have to pick one over the other, so they can take both types of cards plus American Express and Discover.
When a customer uses a Visa card, the transaction information goes through Visa’s private computer network. And when a customer uses a Mastercard, the information is run through Mastercard’s private network. The same is true for all the other credit card companies.
How Credit Card Networks Charge Their Fees
For merchants, running credit card information through different networks means Visa gets to charge a fee for taking Visa cards, Mastercard gets to charge a different fee for taking Mastercard cards, and same for American Express and Discover. This fee is called an interchange fee.
As you can see, a merchant who takes all four major credit cards can face four different charges, and it all depends on which card the customer uses. What is more, the networks usually charge more to process a rewards credit card than a plain credit card.
Interchange fees are charged in a strange format:
- Percent of amount charged + set fee
As far as we can tell from our research, the set fee goes towards using their computer network. The percent-based fee has something to do with what the banks and the card networks want to make on the transaction plus the amount of risk they wish to take per transaction. The riskier your industry, the higher the percentage.
All this means that it’s very difficult for a merchant to predict their monthly credit card processing charges. Some credit card processors called third-party processors or credit card aggregators have tried to even out these charges. So, merchants who use these companies get a more predictable processing charge every month. We’ll go over third-party processors in more detail later in this article.
Credit Card Networks’ Responsibilities in How Credit Card Processing Works
To earn their fee, the credit card networks make and enforce certain rules for the use of their cards. For example, they have security requirements for transmitting credit card information so the information can’t easily be stolen by wrongdoers.
If you use a mobile wallet like Apple Pay or Google Pay, the card networks help encrypt the credit card information before placing it in your smartphone. Then, they help decrypt the information when you use the card in the e-wallet. (This is called tokenization.) Lastly and quite importantly, credit card networks use sophisticated methods to detect credit card fraud to protect the cardholder and the merchant.
Note that most credit card companies also own debit card networks. The debit card networks are technically different from credit card networks. Debit cards also cost differently to process than credit cards. So, it helps a business owner to think of them as different. But, practically and logically speaking, the credit and debit cards of a particular card network probably share a lot of banks, merchants, and some portions of the computer network.
What is an Acquiring Bank?
As issuing banks work with credit card holders, acquiring banks work with merchants who take credit card payments. Like issuing banks, acquiring banks lend money, but they lend money to merchants instead of cardholders.
These days, most merchants can get the money from their credit card sales in 1-3 days. But, in reality, the entire process actually takes up to a week. What’s more, you’re not safe from fraud, refund requests, or chargeback claims for up to 120 days or even more. So, you don’t know your final number from credit card sales until several months after you’ve sold the goods or services.
This is where the acquiring bank comes in. You work with acquiring banks by opening a specialized bank account called a merchant account (we’ll explain more about merchant accounts in the next section).
But before they let you open a merchant account, the acquiring bank will take a look at your business’s credit history, your type of business, and maybe some of your other financial documents. This is to make sure that you’re a real (as opposed to fake) business, and you’re doing business in a way and in an industry they want to lend the money to.
Once the acquiring bank decides that your business is credit-worthy, they basically front you the money you’ll eventually get from your credit card sales. So, when you get your money from credit card sales in 1-3 business days, that money comes from your acquiring bank. The actual money for the actual credit card sales is settled a week or even months later, between the issuing bank and the acquiring bank.
Acquiring banks make money by adding their fees to the total credit card processing fee.
What is a Merchant Account?
A merchant account is a specialized bank account a merchant opens to set up the ability to take credit card payments. The account is opened at the acquiring bank after you pass various credit checks.
A merchant account is not the same as a regular bank account. With a regular bank account, only the account holder gets to take money out of the account. With a merchant account, other folks like your acquiring bank and your credit card processor (see below for definition) are allowed to take money out of the account. The money they take out tends to be related to fees for processing the credit cards for your business.
You get to take money out of your merchant account only after the acquiring bank and the credit card processor have taken out their fees.
What is a Payment Processor?
A payment processor helps a merchant set up everything it needs to take credit (and debit) card payments.
Most of the time, you only work with your payment processor. You almost never work directly with the acquiring bank, the credit card networks, or the issuing banks. While your payment processor can be your acquiring bank too, this doesn’t happen very often. Most of the time, it is your payment processor who helps you with tech support, software, and hardware.
There are two types of payment processors: traditional payment processors and third-party processors (also known as credit card aggregators). We’ll explain both.
How a Traditional Payment Processor Helps You Set Up Credit Card Processing
A traditional payment processor basically connects your business’s credit card hardware and/or software to their own computer system. Then, they act as a traffic cop to send the card information for each payment to the right card network. The card network eventually forwards the information to the correct issuing bank. Then, when the issuing bank clears or rejects a card, the payment processor routes that information back to you.
The payment processor will also sell you the right hardware or license you the right software to make credit card processing work. The hardware you can buy or rent includes card readers, terminals, or point of sale systems (usually consist of a card reader, a display, a scanner for UPC barcodes, a receipts printer, and a cash register). As to the software, you typically license it. You can connect to the software from your computer or from your online store. After that, the card information can be entered from a secure webpage.
A payment processor will also help you set up your merchant account.
Payment processors typically charge per transaction. They take their fees directly from the merchant account, before you can take out the rest of the payment. A typical payment processing fee looks like:
- Percent of amount charged + set fee.
There are large payment processors and smaller payment processors that subcontract with the larger processors. It’s not always cheaper to work directly with the larger processor. Sometimes, you get better customer service and tech support if you work with a subcontractor payment processor.
What is a Third-Party Processor?
A third-party processor is a payment processor that, instead of linking a merchant to its own merchant account, places a group of merchants in a risk pool where they all share a master merchant account. Then the processor uses software to track the credit card sales of each merchant in the pool. This way, they know when and how much to pay each merchant. This is a newer type of payment processing business model.
Third-party processors are sometimes also known as payment aggregators or payment service providers.
Third-party processors tend to be many small startup businesses’ first encounter with the payment processing industry because it’s easy and fast to sign up with them.
Advantages to Working with a Third-Party Processor
Using a pool of merchants to control processing risk lets a third-party processor sign up merchants quickly. They might not even check your credit history. As long as the credit risk of the entire pool is stable, the credit risk of each individual merchant matters less.
Once a new merchant is signed up, the third-party processor can observe the new merchant to get real data on the merchant’s credit worthiness. Third-party processors tend to have multiple merchant pools and constantly mathematically balance the risk profile of each pool.
Compared with traditional processors, third-party processors tend to charge for their services slightly differently. Many traditional processors add a fairly transparent charge to the interchange rate, so you know their costs and their additional charges. This usually means your monthly credit card processing cost can be difficult to predict because the interchange rates for different card networks and different types of cards can vary quite a bit.
Third party processors tend to charge one single rate for in-person payment processing and one single rate for online processing. They charge the same rate no matter which card network or type of card. The rate includes debit cards too. This pricing model gives small businesses more predictability in their monthly credit card charges.
Disadvantages to Working with Third-Party Processors
There are some disadvantages to working with third-party processors. If your business turns out to be a credit risk, third-party processors often stop working with you very suddenly so you’re left with no credit card processor at all.
As well, because they charge a uniform rate for credit card processing, once your business takes off and you start taking a lot of credit card sales, you’re often overpaying in processing fees.
In both these cases, you can save money by switching to a traditional processor.
Simplified Workflow for How Credit Card Processing Works
Now that we’ve introduced the major players in credit card processing and some jargon, we can put everything together and give you a simplified overview of how credit card processing works.
We start right after your customer takes out their credit card or e-wallet to pay:
- Person swipes, taps, or dips the card into the card terminal.
- The terminal reads the card information and sends the information and the amount to be charged to the payment processor.
- The payment processor directs traffic and sends the information to the correct card network.
- The card network performs various checks for fraud. If the information is encrypted (usually via tokenization), the card network decrypts the information and sends it securely to the issuing bank.
- The issuing bank checks the credit limit of the cardholder. If the purchase is within limits, the bank clears the purchase.
- The clearance is sent to the acquiring bank and the payment processor, which, in turn, sends a clearance message to the merchant.
- The cardholder walks away with the purchase.
- The acquiring bank fronts the purchase by depositing the charged amount into the merchant account.
- The payment processor takes out its payment processing fees.
- The merchant takes out the rest of the fees and deposits them into their own bank account that can’t be touched by the acquiring bank or the payment processor.
This is what happens when you have a satisfied customer who is happy with their purchase. Of course, the real world is more complicated. In the real world, you’ll have to deal with unhappy or even angry customers who want their money back.
In our next article, we’ll go over how the credit card process flow deals with these cases.
Questions? Comments?
