How Credit Card Processing Works: Who’s Involved and What Happens?
By Alexandra Sheehan
In 2017, credit cards were used for more than 60% of consumer payments (by dollar spent), according to the Wall Street Journal — more than any other form of payment.
How do those credit card transactions turn into dollars in your business accounts? The answer is credit card processing.
Credit card processing is the system through which the data from a customer’s credit card 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 — 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
When setting the stage for how credit processing works, we have two main components:
- The entities involved
- The steps taken
Let’s dive in.
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, collects the information about the card and the sale, and then requests 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 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.
The steps involved in credit card processing
There are three main steps when it comes to credit card processing:
This is the initial part of the transaction.
- Cardholder presents credit card information to the merchant. This might be entering the number in an ecommerce platform, swiping it at a POS terminal, or relaying it verbally over the phone.
- Merchant sends a request for payment authorization to the payment processor.
- Payment processor sends request to card association.
- Card association sends request to issuing bank.
- Issuing bank approves or denies the request, and sends that message to 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, and that this isn’t a suspected fraudulent charge.
- Card association sends approval/denial to payment processor.
- Payment processor sends approval/denial to merchant.
- Merchant shares approval/denial with cardholder.
- 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 happens after the “physical” transaction has occurred. This is when the issuing bank makes sure the transaction checks out as valid.
- Credit card association requests payment authorization from issuing bank.
- Issuing bank validates that the cardholder account is approved for the transaction and checks the identifying information.
- Issuing bank sends approval or denial to card association and merchant bank.
- Issuing bank places a hold for purchase amount on cardholder’s account.
- At the end of the business day, merchant’s POS terminal batches approved authorizations for processing.
- Merchant sends a receipt to customer as proof of sale.
This is when the merchant actually gets the funds.
- Merchant’s POS sends batched payment authorizations to payment processor.
- Payment processor sends batch to card association.
- Card association sends information to issuing bank.
- Issuing bank charges cardholder’s account for authorized payments.
- Issuing bank subtracts interchange fees for the card association and transfers the rest to the merchant bank.
- Merchant bank distributes money to merchant account.
- Issuing bank posts transaction to 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.
Credit card processing technologies
Credit card payments can happen 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:
- Payment gateway: The software which links the payment terminal to the processing network.
- Payment processor: We mentioned this above as one of the entities involved, and it’s also a key tech component. This is what moves 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, so it’s simply a matter of enabling it on your site and connecting it 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 (POS) terminal as well. As technology develops, we’re also seeing new payment methods: Contactless or mobile pay, for example, accommodates credit card payments but through a different means of tech.
Credit card processing fees
One major consideration 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 processing fees (or merchant discount rate) may be charged in a few ways:
- Flat rate: 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: 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: 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 keep the more expensive fees hidden.
- Membership: 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.
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 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. Chargebacks are increasing 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.
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 choose the best vendor for your unique needs.