How Do Credit Card Payments Work?

Paying with a credit card is so commonplace today that most of our swipes, taps, or dips are processed with little to no thought about what actually makes them work. When your payments are accepted in just a moment, it’s easy to forget that there’s quite a bit going on behind the scenes of our credit card transactions.

As consumers, there’s no real need to understand the complexities of credit card payment processing. But for merchants, it’s important to comprehend the process fully.

There are more than 537 million credit cards in circulation in the United States. The average adult has, on average, 2.14 credit cards, and the total credit available on all those cards across the U.S. is $3.3 trillion. Those are a lot of reasons to accept those cards.

However, it’s possible that you may have wondered at times: how do credit card payments work? In this article, we’ll take a look at everything you need to know about credit cards, from the terminology to the processing of payments.

How Do Credit Cards Work?

When someone makes a purchase with their credit card, the merchant’s payment system sends a request for payment to their bank (Chase, Citi, etc.), known as an acquirer. The acquirer will then forward that request to the customer’s credit card issuer. Once the issuer gets the request, they’ll confirm that the customer has enough credit to cover the purchase and, if so, will approve the transaction.

The issuer will then send a response back to the acquirer, who will, in turn, relay that information back to the merchant. At this point, the funds for the purchase are transferred from the cardholder’s account to the merchant’s account, and the transaction is complete.

This process can happen in a few different ways, but the end result is always the same: the customer pays for their purchase, and the merchant gets their money.

What’s the Difference Between Credit Cards and Debit Cards?

Credit cards and debit cards may look the same, but they work in very different ways. Credit cards are a form of borrowing, while debit cards are linked directly to the customer’s bank account.

When someone uses a credit card, they’re borrowing money from the issuer and will need to pay that money back with interest. When they use a debit card, they’re spending money that they already have in their account.

Credit cards also tend to have much higher credit limits than debit cards. This is because credit cards are a form of loan, and the issuer is taking on more risk by lending the cardholder money. Debit cards, on the other hand, are limited by the amount of money the cardholder has in their account.

Does this matter for merchants?

There are a few reasons why merchants would want to prefer one over the other. But the primary reason is cost.

Credit card processing fees are generally higher than debit card fees. This is because credit card companies view credit cards as a higher risk and therefore charge merchants more to accept them. For merchants who have a lot of high-ticket items, this can mean extremely high fees.

Common Credit Card Terminology Explained

Before we proceed any further, it may be worthwhile to go over some terms commonly used in relation to credit cards and what they mean.  

Credit card balance: This is the amount of money that the cardholder owes to the issuer.

Credit limit: This is the maximum amount of money that the cardholder can borrow from the issuer.

Minimum payment: This is the minimum amount of money that the cardholder must pay each month in order to keep their account in good standing.

APR: Annual Percentage Rate. This is the interest rate that the cardholder will be charged on their outstanding balance if they don’t pay it off in full each month.

Annual fee: Some credit cards charge an annual fee just for having the card. This fee is in addition to any other fees that the cardholder may be charged.

Billing cycle: This is the period of time between each credit card bill.

Cash advance: This is a service that some credit cards offer which allows the cardholder to withdraw cash from their credit line. Cash advances usually come with very high fees.

FICO score: This is a credit score that represents the creditworthiness of an individual. Lenders use it to determine whether or not to approve a loan based on the user’s credit history and credit card debt. If someone has a good FICO score, they have good credit.

Secured credit card: This is a type of credit card that is backed by a deposit. The deposit is usually equal to the credit limit.

Unsecured credit card: This is the most common type of credit card. It is not backed by a deposit and therefore has a higher risk for the issuer.

Available credit: This is the difference between the credit limit and the current balance.

Closing date: This is the date on which the cardholder’s billing cycle ends.

Statement balance: This is the balance that is listed on the cardholder’s monthly statement. It may be different from the current balance because of payments or credits that have been applied since the statement was generated.

Statement due date: This is the date on the credit card account on which the cardholder’s monthly statement is due.

Minimum interest charge: This is the minimum amount of interest that the cardholder will be charged each month, even if their balance is zero.

Late payment: This late fee is charged to the cardholder if they do not make their minimum payment by the due date.

Returned payment: This is a fee that is charged to the cardholder if their payment is returned for any reason.

Over-the-limit fee: This is a fee that is charged to the cardholder if they exceed their credit limit.

Foreign transaction fee: This is a fee that is charged to the cardholder for making a purchase in a foreign currency or from a foreign country.

Grace period: This is the period of time between the end of the billing cycle and the due date during which the cardholder can pay their balance without being charged interest.

What Are the Different Types of Credit Cards?

There are many different types of credit cards available, each with its own set of features and benefits. Some of the most common types of credit cards are:

• Rewards credit cards: These cards offer rewards such as cash back, points, or miles for every purchase that is made.

• Balance transfer credit cards: These cards offer a 0% APR for a promotional period, which can help cardholders save money on interest charges.

• Secured credit cards: These cards require a deposit in order to open an account and usually have lower credit limits than unsecured cards.

• Unsecured credit cards: These are the most common type of credit card and do not require a deposit.

• Business credit cards: These cards are designed for business owners and offer special features such as employee cards and spending limits.

• Cash back credit cards: These cards give cardholders a percentage of cash back on every purchase that is made.

• No annual fee credit cards: These cards do not charge an annual fee, which can save cardholders a lot of money each year.

• Low-interest credit cards: These cards offer low interest rates, which can help cardholders save money on their monthly payments.

Does this matter for merchants?

The main type for merchants to be wary of is the unsecured credit card. This type is not backed by a deposit and therefore has a higher risk for the issuer. Because of this, unsecured credit cards usually come with higher processing fees than other types of credit cards.

The secured credit card, comparatively, is one of the best credit cards for merchants to accept to reduce fees. This is because it’s backed by a deposit, which is usually equal to the credit limit. Secured credit cards typically have lower processing fees than unsecured credit cards.

Outside of those two, other credit card types don’t tend to change the fees payable by merchants, only the way in which cardholders pay their own fees.

How Credit Card Payments Work

Now that we’ve discussed how payments are processed between the merchant’s bank account (acquirer) and the card networks (issuer), let’s take a look at the fees accumulated throughout this process. There are three main types of fees that are associated with credit card payments: 

• Interchange fees are paid by the acquirer to the issuer and are a percentage of the transaction amount. The average interchange fee is around 1.5%.

• Assessment fees are paid by the acquirer to the card brands (Visa, Mastercard, American Express, Discover, etc.) and are a flat fee per transaction. These fees are used to cover the cost of things such as fraud prevention and rewards programs.

• Processing fees are paid by the merchant to their acquirer and are either a flat fee or a percentage of the transaction amount. These fees cover the cost of things such as customer service and chargebacks.

At every step, each institution in the process takes its slice of the pie. It’s particularly important to familiarize yourself with all parties to avoid confusion when reviewing your payment processing statements.

Common Credit Card Fees for Consumers

There are a number of fees that are commonly charged to credit cardholders: annual fees, late payment fees, balance transfer fees, foreign transaction fees, and cash advance fees.

• Annual Fees: Many credit cards charge an annual fee simply for having the card. These can range from $0 to over $500.

• Late Payment Fees: If a cardholder doesn’t make their minimum payment by the due date, they will likely be charged a late payment fee. This fee is typically around $35.

• Balance Transfer Fees: When cardholders transfer a balance from one credit card to another, they will often be charged a balance transfer fee. This fee is typically around 3% of the balance being transferred.

• Foreign Transaction Fees: When cardholders use their credit card to make a purchase in a foreign currency, they will often be charged a foreign transaction fee. This fee is typically around 3% of the transaction amount.

• Cash Advance Fees: When cardholders take out a cash advance from their credit card, they will often be charged a cash advance fee. This fee is typically around 5% of the cash advance amount.

There are also APRs. Annual Percentage Rates are the interest rates that are applied to credit card balances. These include balance transfer APRs, purchase APRs, cash advance APRs, and penalty APRs.

• Balance transfer APRs are the rates that are applied to balance transfers. These rates are typically lower than purchase and cash advance APRs.

• Purchase APRs are the rates that are applied to new purchases. These rates can be either fixed or variable.

• Cash advance APRs are the rates that are applied to cash advances. These rates are typically higher than purchase and balance transfer APRs.

• Penalty APRs are the rates that are applied to cardholders who make late payments or go over their credit limit. These rates are typically higher than purchase, balance transfer, and cash advance APRs.

The Bottom Line

Accepting credit cards in your business is a must, but it’s important to understand how they work before you do so. This will help you avoid any confusion when reviewing your payment processing statements and assessing your personal finance.

Reviewing credit card processing from both the merchant and consumer perspective helps you to develop a well-rounded understanding of how credit cards work. As a merchant, it’s important to understand the fees that you’ll be charged for accepting credit cards. Understanding the consumer fees, too, ensures you can handle any questions and concerns they may have when using their credit card with you.

If you’re looking for an easy, hassle-free way to accept credit card payments, look no further than Payment Depot. Our membership-based pricing with zero markups, no contracts, and no hidden fees helps small businesses like yours save more as you process more. Contact us today to learn more about how we can help your business grow.