How Credit Card Processing Works: Who’s Involved and What Happens?

In 2021, credit, debit, and mobile wallet payments represented 81% of all American payments, according to Statista. In other words, card transactions are the most popular way to pay by a long shot. Small business owners should know that consumers now expect even the very smallest businesses to accept their credit cards.

How do those credit card transactions turn into dollars in your business accounts? The answer is credit card processing. It’s important to note that the payment processing system has evolved in the past few years to adhere to new PCI compliance guidelines. Now, most processing solutions also take chip cards, online payments, and digital wallet transactions. Now credit card processing companies also process a variety of mobile payments like Apple Pay, Google Pay, and Samsung Pay.

Credit card processing is the system through which the data from a customer’s credit or debit card, either physical or digital, is transmitted to approve a dollar transaction from their accounts to the merchant’s account. It’s the phrase given to the entire process, from the moment the customer provides the credit card information through the time the funds are accessible to the recipient.

You might think it’s not so important to understand the inner workings. But the more you understand how credit card processing works, the better you can choose a processor for your company. And, not to mention, negotiate the best vendor agreement.

Let’s look at how credit card processing works and which components you need to consider.

How Credit Card Processing Works

How does credit card processing work? At a glance, the act of accepting credit cards would look like this:

• The customer presents their credit card info to the merchant

• The card information is sent to the payment processor for authorization 

• The processor sends the request to the issuing bank to verify that the cardholder’s credit or bank account is in good standing

• The bank approved or denies the request

• That approval/denial is sent back to the processor, who then sends it to the merchant

• The merchant either completes or cancels the sale based on whether or not the card was approved 

All of this happens within a matter of seconds, but as you can see there is a lot of technical work that happens quickly behind the scenes.

Steps Involved in Credit Card Processing

In the section above, we gave a very high-level view of credit card processing. While the whole thing seems quick and simple, there are actually a number of players and steps involved in the process. There are also a number of variations on the above scenario, such as with online purchases or card-not-present transactions. Let’s look at them in more detail below.

Who’s Involved in Credit Card Processing?

Credit card processing is a multi-step process (which we’ll look at in just a bit), and different individuals and/or companies are involved at each step. Here’s who’s who:

• Cardholder, customer, consumer (for DTC businesses): This is the person who wants to buy the product or service. They apply and obtain a line of credit and then provide the information for their credit card to make the purchase.

• Merchant, store, seller, vendor: The company which is selling the product or service to the cardholder. The merchant accepts credit cards or mobile payments. Then they collect the information about the card and the sale. Finally, they request payment authorization. In a brick-and-mortar store, this is often done on a point-of-sale (POS) system.

• Merchant bank, acquiring bank: This is where the merchant has an account, and credit card payments are deposited to these accounts. This bank receives the payment authorization request, sends it, and shares the response to the merchant. The merchant services bank is also the payment processor in some cases.

• Payment processor, acquiring processor: The company which processes the credit and debit card transactions for the merchant, as well as provides the hardware to conduct credit card transactions for in-person sales. Sometimes the payment processor is the merchant bank, and sometimes it’s a third party.

• Independent sales organizations (ISOs): Sometimes, merchant banks don’t process the payment. They may “outsource” this to a third-party ISO.

• Membership service providers (MSPs): Like ISOs, MSPs are another entity that merchant banks may enlist to process payments and manage daily transactions on their behalf.

• Issuing bank, credit card issuer, cardholder bank: This is the bank with which the cardholder has an account(s). They provide credit, so the cardholder can make purchases. Issuing banks may be banks, credit unions, and other financial institutions.

• Card associations, credit card networks, association members: Major credit card brands like Visa, MasterCard, Discover, and American Express are card associations. They set the policies and standards for payment processing (such as interchange fees), as well as serve as the middle man between issuing banks and merchant banks.

What Are the Payment Processing Types Available to Customers?

We’ve already mentioned more than a few things that customers can use in a “credit card” transaction. So let’s talk about what exactly should a merchant expect to need their payment processor for.

Modern payments break into two main types: plastic cards and mobile payments.

Plastic card transactions are still the classic payment method, making up for 70% of payments according to Forbes. These cards can represent either a customer’s debit or credit account. That said, plastic cards themselves now offer a few methods of transmitting data to the merchant.

• Cards can still swipe a magnetic strip. However, this method is phasing out due to security issues.

• In order to adhere to PCI compliance, plastic cards now utilize an EMV chip to dip into the terminal. This EMV chip is meant to completely replace the magnetic strip method over time as it’s far less susceptible to credit card fraud.

• Many plastic cards now also contain an RFID chip to provide contactless payments. With such a chip, the customer can tap their card against the terminal to enable to card to communicate with the payment terminal via near-field communication technology.

Mobile payments are rising in popularity—reaching 11% of all transactions in 2021, says Forbes. Mobile payments can most simply be described as a transaction that takes place using the customer‘s mobile device. However, there is a huge amount of flexibility in what that looks like. Even the device itself can vary a lot. Today’s consumers use phones, iPads, and even smartwatches to pay. That said, most consumers use a mobile wallet like Apple Pay, which stores their credit and debit information digitally to essentially act as a plastic card with an RFID chip.

Three Main Steps in Credit Card Processing

There are three main steps when it comes to credit card processing:

1. Authorization
2. Authentication
3. Settlement

Authorization

This is the initial part of the transaction.

1. The cardholder presents credit card information to the merchant. This might be entering the number in an eCommerce platform, swiping it at a POS terminal, tapping the EMV chip, presenting their mobile device, or relaying it verbally over the phone.

2. The merchant sends a request for payment authorization to the payment processor.

3. The payment processor sends the request to the card association.

4. The card association sends the request to the issuing bank.

5. The issuing bank approves or denies the request, and sends that message to the card association. The issuing bank includes the credit card number, expiration date, billing address, security code, and payment amount in this message. A cardholder might be declined for a purchase if they have insufficient funds/credit, given that this isn’t a suspected fraudulent charge.

6. The card association sends approval/denial to the payment processor.

7. The payment processor sends approval/denial to the merchant.

8. The merchant shares approval/denial with the cardholder.

9. In the case of approval, the merchant would provide the good or service (if they haven’t already). In the case of denial, the card would be declined, and the cardholder would have to choose a different payment method. (This is part of the reason why it’s good to accept multiple payment options for your customers.

Authentication

Authentication happens after the “physical” transaction has occurred. This is when the issuing bank makes sure the transaction checks out as valid.

1. The credit card association requests payment authorization from the issuing bank.

2. The issuing bank validates that the cardholder account is approved for the transaction and checks the identifying information.

3. The issuing bank sends approval or denial to the card association and merchant bank.

4. The issuing bank places a hold for the purchase amount on the cardholder’s account.

5. At the end of the business day, the merchant’s POS terminal batches approved authorizations for processing.

6. The merchant sends a receipt to the customer as proof of sale.

Settlement

This is when the merchant actually gets the funds.

1. The merchant’s POS sends batched payment authorizations to the payment processor.

2. The payment processor sends the batch to the card association.

3. The card association sends the information to the issuing bank.

4. The issuing bank charges the cardholder’s account for authorized payments.

5. The issuing bank subtracts the interchange fees for the card association and transfers the rest to the merchant bank.

6. The merchant bank distributes the money to the merchant account.

7. The issuing bank posts the transaction to the cardholder’s account statement.

How to Accept Credit Card Payments

If you want to accept credit card payments in your business, it begins with getting the hardware and software you need.

Types of Credit Card Payment Processing Technologies

Credit card payments can happen in two main ways: online and in-person. Depending on how you process credit card payments in your business, this will determine what types of technology you’ll need to get all set up.

Before we dive into that though, there are two technologies that all card processing methods have in common:

1. Payment gateway: The software which links the physical payment terminal or online virtual terminal to the processing network.

2. Payment processor: We mentioned this above as one of the entities involved, and it’s also a key tech component. This technology has the functionality to move the transaction through each phase and entity along the process.

But there are sometimes other technologies you need to consider. Online is arguably more simple and straightforward. Many eCommerce platforms have some sort of credit card payment processing built in. It’s simply a matter of enabling it on your site and connecting it to your business accounts.

When it comes to in-person payments, you’ll also need to acquire the terminal which physically facilitates the payment. This includes a credit card reader and, for some, a point-of-sale system (POS system) terminal as well. As technology develops, we’re also seeing new payment methods: Contactless or mobile payments, for example, accommodate credit card payments but through a different means of tech, often a tiny mobile card reader from a company like Square.

Whatever the case, if you want to get the most out of your payment technologies, it’s important to do your research and find vendors who will provide you with the tools you need at reasonable prices.

Credit Card Processing Fees

One major consideration for business owners in choosing a credit card payment processor is the cost. Credit card processing fees vary for every vendor, and some pricing structures will work for you while others may work against you. Credit card fees can become a debilitating cost for particularly small businesses, so it’s very important to know exactly what you’re signing up for.

Credit card processing costs (or merchant discount rate) may be charged in a few ways:

• Flat rate pricing model: You owe a fixed amount or percentage for every transaction, no matter how large or small the order is. Many times, credit card processors will apply a flat fee per transaction plus a percentage of the transaction. (For example, $0.30 + 2.5% of the transaction amount.)

• Interchange-plus pricing: Like a flat rate, you’ll pay a certain amount for each transaction, a percentage of that transaction (typically lower than the flat rate percentages), and the interchange rate on top of the fees to your payment processor. Interchange fees vary, so you’ll need to research what this means for your particular situation.

• Tiered pricing: These rates are established based on pricing tiers: qualified, mid-qualified, and nonqualified. Be careful with this pricing structure; many processors will advertise the most attractive qualified rates and then hit you with expensive hidden fees after signing.

• Membership pricing: This pricing structure requires a monthly membership fee, and often includes a small per-transaction fee on top of that, depending on your plan. This is ideal because your payment processing expenses are always predictable.

Check out Payment Depot’s Monthly Membership Pricing >

Regardless of the fee structure your processor has, merchants pay a few specific expenses, all of which are accounted for in the fees listed above:

• Assessments: This goes to the credit card association, typically a percentage. These fees vary depending on the credit card brand and your pricing structure.

• Interchange fee: This is the price the merchant bank and payment processor pays to the issuing bank. Each credit card network charges its own interchange fees (except American Express).

• Markups: Merchant banks and payment processors will charge this fee as a way to generate revenue and cover any costs associated with transmitting information and funds.

• Chargebacks: Chargebacks aren’t really an associated expense with every credit card transaction, but they are a real threat to consider as they’re one of the most common forms of credit card fraud. Chargebacks are increasing by 20% each year, and merchants bear the financial burden. An issuing bank will charge the merchant a fee each time a customer files a chargeback request.

Related: Find out how to fight chargebacks and keep your hard-earned money >

Understanding Credit Card Processing and Your Business

Sure, understanding the technical backend of what happens when a credit card is swiped might be TMI. But having a base knowledge of how credit card processing works and what it means for your business can help you save money and be more efficient. 

By knowing each step of the payment process—and the parties involved—you’ll know exactly who’s taking a cut out of your sales (or who you’re paying) and why. This, in turn, will ensure that you choose the best credit card processing vendor for your business needs.

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Quick FAQs about Credit Card Processing

Q: What is credit card processing?

Credit card processing refers to the system that transmits data from a customer’s credit or debit card to approve a transaction from their accounts to the merchant’s account. It’s the process that starts from the moment the customer provides the credit card information until the funds are accessible to the recipient.

Q: Who is involved in credit card processing?

Several parties are involved in credit card processing. These include the customer or cardholder, the merchant or seller, the merchant bank, the payment processor, independent sales organizations (ISOs), membership service providers (MSPs), the issuing bank, and card associations like Visa, MasterCard, Discover, and American Express.

Q: How long does it take for a credit card transaction to process?

Credit card transactions typically take just a few seconds to process. The payment processor communicates with the card issuer to approve or decline the transaction. However, the funds may take a few days to transfer to the merchant’s account.

Q: What fees are associated with credit card processing?

Merchants typically pay a processing fee for each credit or debit card transaction. The fee varies depending on the type of card, the transaction amount, and the merchant’s processing agreement with their payment processor. Some common fees include interchange fees, processing fees, and chargeback fees.

Q: What is a chargeback?

A chargeback occurs when a customer disputes a credit card transaction and requests a refund. Merchants should work with their payment processor to investigate the chargeback and provide any necessary documentation to dispute the claim.

Q: Can merchants accept credit card payments online?

Yes, merchants can accept credit card payments online through various channels, such as their website, mobile app, or social media platforms. However, accepting online payments requires additional security measures to protect against fraud and ensure that transactions are processed securely.

Q: What are the main steps involved in credit card processing?

The main steps include authorization, where the customer presents their card information and the merchant sends a payment request; authentication, where the issuing bank validates the transaction; and settlement, where the merchant receives the funds.

Q: How do businesses ensure the security of credit card transactions?

Businesses can take several steps to ensure the security of credit card transactions, such as using an encrypted payment gateway, requiring strong passwords for their payment processing account, and regularly monitoring their transactions for signs of fraud or suspicious activity.

Q: How do credit card processing costs affect small businesses?

Credit card processing fees can become a significant cost for small businesses. It’s crucial for businesses to understand their processing agreement and the associated costs to ensure they are not overpaying for these services.

Q: What technology is needed for credit card processing?

Businesses need a payment gateway and a payment processor to handle credit card transactions. For in-person payments, a terminal that facilitates the payment, including a credit card reader and a point-of-sale system (POS system) terminal, may also be required. For online payments, many eCommerce platforms have built-in credit card payment processing.

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