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Understanding Payment Card Processing

Scott Coburn

Credit card processing (or merchant services) can be rather confusing, as there are many moving parts in the process that takes place when a customer pays by credit card. In this blog, we will cover the basics on credit card processing. This will help you understand the entities involved and their roles in the process.

Every credit card transaction involves four parties:
  1. The merchant receiving the payment (“merchant”)
  2. The bank that the merchant uses to provide processing services (“acquiring bank”)
  3. The bank that issued the card to the customer (“issuing bank”)
  4. The customer (“customer”).

The process begins by issuing bank lending the money to the customer. The customer will pay off the debt within the grace period (typically 30 days) or it’s add to balance with the interest. The acquiring bank is the one who makes the loan to the merchant. Both the issuing and acquiring bank issue the fees associated with the transaction.

The Fees Involved:

The fee assessed by the issuing bank is called the interchange fee. The fee assessed by the acquiring bank is called the discount rate, which also may be supplemented with other fees. Both the interchange fees and the discount fees are expressed as percentages of the transaction.

Many banks issue credit cards to customers and act as issuing banks. These banks hand out cards of a certain brand, with Visa, MasterCard and Discover the most common. American Express is a little different however. It acts as both the issuing and the acquiring bank and charges a single fee directly to the merchant. However, it will administer the transaction through the acquiring bank. This is so a merchant can process American Express transactions through the same terminal as the other cards.

Those interchange rates are published information — you can see Visa’s fee structure here and MasterCard’s here. The exact interchange fee charged to the acquiring bank (and the merchant) is determined by several factors: whether the card is present at the transaction, what type of card is used (a rewards card a card used by the government for purchasing?) and what type of merchant accepts the card.

Additionally, the type of business you are in can affect the interchange rates. This is because the issuing bank seeks compensation for the risk of a chargeback.

Chargebacks:

A chargeback takes place when a customer successfully disputes a charge with their credit card.

A chargeback involves a customer complaint with the product or service you have provided where the customer does not feel they received what they paid for. In these cases, chances are good that the money you were paid by the acquiring bank, plus additional fees, will be taken out of your account. Chargebacks can be appealed, but it takes time to investigate a chargeback and you may find yourself on the losing end of the decision.

Some businesses are more likely than others to provoke chargebacks. The safest transactions, from the point of view of both issuing banks and acquiring banks, occur when the cardholder is physically present to swipe the card and sign the receipt and when the goods are inexpensive and unlikely to provoke complaints. The safest merchandise and services are the ones that are standard and used the quickest. This is why  gas stations, restaurants and car rental agencies get favorable rates.

Risky Transactions:

Transactions done over the phone or internet are usually the trickiest. Especially if the transaction is large and the type of business is one that generates complaints. That’s why an important part of applying for merchant services is revealing what kind of business you are. To make sure everyone is speaking the same language, the processors employ MCC Codesfour-digit numbers issued for a wide variety of businesses as defined by the federal government. If you wade through the MasterCard interchange document I linked to above, you will see special interchange rates associated with different MCC codes. Visa works the same way.

Acquiring Bank:

If you need to accept credit cards for your business, you have to deal with the acquiring bank. The acquiring bank often splits the responsibilities between two entities. The first, commonly called the merchant service provider, is in constant contact with the merchant. When a sales representative shows up at your door to try to sign you up for credit card processing, or when you interact with a Web site (such as Square) to investigate a deal, you are dealing with the merchant service provider, which can be an arm of a bank or a smaller independent company.

In every deal I looked at, standing behind the merchant service provider was another company. I’m not sure if this is the correct term, but I’ll call it the processing company. This entity actually executes the mechanics of the transaction: transmitting information among the merchant, the issuing bank and the acquiring bank. In my dealings with four merchant service providers, I found it difficult to tell exactly how the duties of the acquiring bank were divided between the merchant service provider and the processing company. The sales representatives clearly worked for the merchant service provider. The monthly statement could come from either the merchant service provider or the processing company. The card readers were provided by the processing company. And somewhere in the middle were the underwriters.

Underwriting:

Is someone evaluating risk? Absolutely. It is important to understand that when you sign up to accept credit card payments, you are actually borrowing money. When the acquiring bank transfers cash to the merchant, it is assuming the risk that there will be a chargeback.  When the transaction is complete and the warranty on the goods expire, the risk disappears.

Despite that risk, the acquiring bank will put the transacted funds in the merchant’s account two or three days after the transaction is reported. The acquiring bank sees this as a loan. This is why when you apply for merchant services, your fitness to borrow the amounts that your business generates in credit card transactions will be evaluated.

And as with any personal guarantee, this is likely to affect your credit score and your ability to borrow money outside your business. At the very least, if you shop around for merchant services, as I did, your personal credit report will show multiple inquiries, which could have an impact on your credit score.

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