How Do Credit Cards Work?
An Overview for Your Business
This guide introduces you to a key idea for understanding how credit card payments work: that accepting a credit card payment is essentially the same thing as receiving a temporary loan from an acquiring bank.
From there, we provide an overview of the processes, key players, and fees involved when your business begins accepting credit card payments, along with helpful links to comprehensive guides on each subject.
Table of Contents
Why a Credit Card Payment is a Loan
When you accept a credit card payment, you’re receiving a loan until the time when the person paying you with a credit card can no longer dispute the charge.
This loan requires an agreement with a payment processor and a bank (called a “merchant acquirer” or “acquiring bank”). Together, the acquiring bank and payment processor manage the merchant’s end (your end) of the credit card payment process. Here’s how:
- The acquirer assumes responsibility for the funds deposited in your account for each credit and debit card payment you receive, and
- the payment processor handles the technical side of the process.
Sometimes a payment processor and an acquiring bank or one and the same (as with some larger acquiring banks). More often, the payment processor is a third-party provider.
For both the payment processor and the acquiring bank this is a risky business.
Your customers can dispute debit card transactions for around 3-6 months or more after the payment gets made, and traditional credit cards are even worse—around 1 year or more.
Moreover, the payment dispute or “chargeback” timeline also depends on the brand of the card your customer uses. Visa and Mastercard, for instance, have similar chargeback timelines, but if you accept American Express credit cards, forget about it! You’re giving your customers years to dispute their charges.
- So let’s say you run 10 million bucks through your payment processor in a year. That’s 10 million bucks your processor transfers and your acquiring bank deposits without knowing for sure if huge chunks of those transactions will result in payment dispute (or chargebacks) at some point down the road.
This is why your payment processor wants to know so much about your business before negotiated the terms of your contract – things like sales volume, average ticket, refund policies, web security (if you make sales online), your business’s chargeback history, and the types of goods or services you provide.
Different types of transactions and types of businesses make a huge difference to the level of risk they’re taking on, and so they use that information to adjust the rates and terms they’re willing to give your business.
How Credit Card Payments Work
We can better understand why accepting a credit card payment is a loan and why credit card processing is a risk-driven industry by taking a closer look at the key players, processes, and fees involved whenever you accept a credit card as payment.
However, the discussion that follows is only an overview of each of these crucial topics. For a deeper dive, simply follow the links to our comprehensive, subject-specific guides in each of the sections below.
The Key Players
In a nutshell, credit card payments involve several key businesses that more or less “share” the liability that comes with every payment made with a credit card. As we mentioned in the introduction above, payment processors and acquiring banks handle the merchant’s end of the process, but what about consumers?
That privilege belongs to credit card “issuers” or “issuing banks.” These are either banks that issue credit cards licensed by credit card networks, as with Visa and Mastercard credit cards, or cards issued by the card brands themselves, as with American Express and Discover. In either case, the issuing bank allows the consumer to use the credit card, authorizes individual transactions, and assumes financial responsibility for each credit card payment.
The real credit card lords, however, are the credit card networks themselves. These card networks, card brands, or card schemes (all equivalent terms) decide where their cards can be accepted, set the interchange or “swipe” fees for each transaction, charge their own fees (called assessments), and dictate the rules acquiring banks, payment processors, and merchants have to follow. It’s hard to say if the credit card networks are the eye of the storm or the storm itself, but, in any case, they play an essential role in the credit card payment process.
The Credit Card Payment Process
The credit card payment process takes place in two broad stages: “authentication & authorization” and “clearing & settlement.”
Authentication & Authorization
The first stage—authentication & authorization—consists of what most of us associate with the credit card payment process. The customer presents a card as payment (face-to-face, by mail, by phone, or online). The merchant then transmits the cardholder’s information, along with an “authorization request,” through various intermediaries until it reaches the cardholder’s issuing bank. These intermediaries include a payment gateway if the sale is made online, a payment processor, and the credit card networks.
The issuing bank then analyzes the transaction, verifies the card information, checks it for signs of fraud, checks the payment amount against the cardholder’s line of credit (or bank account if it’s a debit card payment), and then issues a response—approved or declined—that travels back through the same intermediaries until it reaches the merchant who completes the sale.
Clearing & Settlement
What’s interesting is that even though a “payment” has been made when a transaction has been authorized, no money has actually changed hands, and no money has even been transferred from one account to the other. That only happens once the merchant performs a “batch close” (manually or automatically at a set time) and sends the batched transactions through its payment processor to each of the appropriate credit card networks.
This is the so-called “clearing & settlement” stage of the credit card payment process. During clearing and settlement, all the big players starting communicating with each other, transactions of a particular type get categorized and assigned specific interchange rates and assessment fees, and the actual money (less fees) starts to change hands.
Credit Card Processing Fees
Every credit card transaction draws a locust-like swarm of credit card processing fees. Some of these fees are set by the credit card networks and can’t be negotiated, while others depend on your payment processor and the terms of your business’s merchant agreement.
The non-negotiable fees you’ll pay are often called “wholesale fees,” and they include interchange fees paid to a cardholder’s issuing bank and assessment fees paid to the credit card networks. Together, interchange fees and assessments will make up a whopping 75% to 90% of your overall processing costs.
The rest of your credit card processing costs come in the form of payment processor markups and other service fees, but not all payment processors will charge you in the same way. Instead, they’ll use one of a few common credit card pricing models (described below) to calculate the fees you’ll pay for each transaction.
3 Common Credit Card Pricing Models
Flat-rate pricing plans charge a flat fee for each transaction, though the processor’s flat fee might change depending on the transaction type (for instance, card-present vs. card-not-present transactions). Flat-rate pricing looks simple, on the surface, but businesses that process a lot of payments at a higher volume will often pay higher overall processing costs in the long run.
Tired pricing plans categorize transactions into “tiers” and charge a different rate for each tier. The details vary, but in general lower risk transactions and transactions involving basic consumer cards come with the lowest fees, and higher risk transactions and rewards cards generate higher fees. Credit card processors that offer tiered plans tend to advertise their lowest rates, so it’s important to pay close attention to which tiers your typical transactions will actually qualify for.
Interchange-plus pricing passes interchange fees and assessments directly through to merchants, and the payment processor tacks on separate transaction fees of its own. In this case, your overall credit card processing costs will vary depending on the wholesale fees charged for each transaction. In general, interchange-plus plans are the most “transparent” plans available, since you can distinguish wholesale fees from markups on your monthly statements, and they are often also the cheapest option available for businesses with high sales volumes.
Chargebacks (Payment Disputes)
Finally, there’s the issue of payment disputes or credit card “chargebacks.” Chargebacks are essentially forced refunds prompted by a cardholder’s issuing bank (usually at the customer’s request). And they amount to an endless headache for merchants, payment processors, and acquiring banks alike. (If chargebacks were flowers, they’d have a name like “merchant’s bane.”)
More charitably, the chargeback process is how the card payment industry protects consumers against identity theft, merchant fraud, and defective products. Anyone buying goods or services with a credit card is, after all, at a basic disadvantage. They are all small fish in an ocean-sized pond populated by banks, massive credit card networks, and merchants who may or may not provide honest service or legitimate products. So the credit card chargeback process partly serves to even the playing field for consumers.
But for merchants chargebacks are one form of consumer protection that’s still hard to love. The chargeback process is heavily-weighted in the cardholder’s favor, and because disputing a chargeback can be costly and time-consuming, merchants often just bite their lips, pay the required chargeback fees, and take the chargeback itself as a loss—even when they believe the chargeback is illegitimate.
That isn’t the approach we recommend. Instead, we think you should explore how credit card chargebacks work, understand what qualifies as a legitimate chargeback, and know the steps you can take to defend your business. A chargeback is always a loss for your business, one way or another, but it still pays to know how best to prevent chargebacks, how to fight them when necessary, and how to lessen the impact of a chargeback when one occurs.
The Key Takeaway
There’s no getting around it: Understanding credit cards is a difficult—but it’s doable—and it helps to remember that accepting credit card payments is a loan. This is the key idea we explored explicitly in our introduction and implicitly throughout this Guide on How Credit Cards Work. In fact, every subject we explored here really gets its life from this basic idea.
The complexities of the credit card payment process reflect how issuing banks and acquiring banks both fund loans that carry boatloads of risk. Buyers paying with credit cards may not actually make their payments, after all, but issuing banks have already funded those payments in advance and assumed the liabilities involved. Similarly, acquiring banks are ultimately responsible for sending the funds from successful chargebacks to the cardholder’s issuing bank. This is true even when the merchant has gone out of business or can’t otherwise pay.
These risk—and the loans that cause them—are likewise reflected in the credit card processing fees your business pays to accept credit card payments. Interchange fees go to issuing banks to offset their risks. Assessment fees go to the credit card networks to offset their risks. And your payment processor adds its markups and service fees partly to mitigates its risks, as well.
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