A Practical Guide to Understanding Interchange Fees

A Practical Guide to Understanding Interchange Fees

As consumers resume their pre-pandemic credit card usage, CNBC reports a rise in card balances. This sharply contrasts with the credit card debt pay downs that occurred in 2020.

To illustrate, the Federal Reserve issued its G.19 report on consumer credit usage in May 2021. It noted that credit card balances collectively increased 11% from April to May. This represents the largest increase in 5 years, using an annualized framework.

Infographics Interchange Fees 1

With increased market potential, retailers want to maximize their profits by minimizing credit card processing fees. In this article, we’ll help you learn how the interchange fee fits into the equation and how merchants can lessen its impact.

Let’s dive in.

Interchange fees the basics: Interchange fees are charges that merchants pay to card-issuing banks for processing credit card transactions. These fees can significantly impact operating costs and pricing strategies for businesses. Understanding and managing these fees effectively is crucial for maintaining profitability.

Interchange fees defined 

The term “interchange fees” is the shortened version of “interchange reimbursement fees.” These are the fees that businesses are compelled to pay to card-issuing banks as reimbursement for lost card interest. Banks lose interest when cardholders use the grace period to repay their debts.

The interchange’s multiple categories determine the rate for an individual credit card or debit card transaction. Each category features eligibility requirements along with a corresponding interchange rate. To understand how interchange fees work, it is essential to know that they are involved in every card-based transaction, covering the process of transaction initiation, authorization, approval, and settlement, and the allocation of interchange fees between acquiring and issuing banks.

What do interchange fees cover?

An interchange fee applies to each credit card or debit card sales/service transaction. Examples include a retailer’s product sale or a field-based plumbing services payment. During the transaction, the merchant’s bank (the acquiring bank or acquirer) pays an interchange fee to the customer’s bank (or issuing bank).

The interchange fees cover the issuing bank’s fraud transaction risks. In addition, the fees pay for transaction processing costs. Proper and complete transaction data is crucial for credit card transactions, especially for card-not-present transactions and for dealing with corporate and government cards. An interchange fee is derived by applying a specific interchange rate (or percentage) to the purchase amount.

Credit card interchange fees range from 1.5% to 3.3% on average. Payment processing fees are an additional expense. Note that Visa card transactions carry the lowest fees. However, Mastercard and Discover transactions incur only minimally higher costs.

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Interchange fee regulations

Since 2010, interchange fee regulations have helped to govern the payment card industry. The Durbin Amendment, a component of the Dodd-Frank Wall Street Reform and Consumer Protection Act, creates a ceiling on debit card transaction fees on sales. US Senator Richard J. Durbin introduced the amendment in 2010.

The cost of interchange fees is a major part of the costs for businesses accepting card payments. These fees can significantly impact operating costs, pricing decisions, cash flow, and the overall business model.

Before Sen. Durbin designed the amendment, interchange fees averaged $0.44 per transaction (using a range of 1% to 3% of the transaction amount). Sen. Durbin expressed his opinion that the existing interchange fees were unreasonable and not in proportion to the card issuers’ costs.

In his amendment, Sen. Durbin proposed an interchange fee ceiling of $0.12 per transaction for banks that held at least $10 billion in assets. As often happens with in-process bills, however, legislators’ compromises watered down the original bill’s provisions.

When the bill was finally passed into law in 2010, the interchange fees were given a per-transaction cap of $0.21 plus 0.05% of the transaction amount. Not surprisingly, some banks took action to compensate for their interchange revenue decreases. These financial institutions discontinued certain free services, and introduced new fees, to make up for the shortfall.

Infographics Interchange Fees 3

Who sets interchange fees?

Credit card networks (or credit card associations) establish their respective interchange fees. Mastercard, Visa, American Express, and Discover are the major credit card networks (or credit card companies).

There are three primary types of interchange pricing models used by payment processors for billing businesses for interchange fees associated with card transactions. These models include tiered pricing, interchange-plus pricing, and flat-rate pricing, each with its own characteristics such as transparency, predictability, and cost fluctuation.

For perspective, American Express and Discover each operates as both a credit card association and an issuing bank. In comparison, Mastercard and Visa place their logo on cards from a card-issuing bank. The issuer assumes the risk of extending credit to consumers with sometimes-shaky repayment histories.

Interchange fees make up the biggest portion of credit card processing costs for merchants. Some estimates say that interchange fees comprise 70% to 90% of total card processing fees. For larger merchants, interchange fees make up a smaller percentage of their card transactions expenses.

Who keeps the interchange fees?

Many merchants believe their merchant account provider keeps the interchange fees. However, the provider only serves as a conduit, passing the interchange fees to the card-issuing bank (or issuer).

Merchants pay a small network fee for each transaction. This charge is split between the provider’s markup and the credit card association. The retailer’s merchant services provider also assesses varied fees on a per-transaction and monthly basis.

How often are interchange fees updated?

Certain major card networks revise their interchange fees annually. Mastercard and Visa update their interchange fee schedules in April and October. The updates usually include some rate increases along with rate reductions. It is crucial to review processing statements regularly to stay aware of any changes in interchange fees and understand all the fees being charged by the payment processor. To illustrate, American Express decreased its credit card processing fees in 2018.

Planned fee update logistics 

Mastercard and Visa have discussed plans to implement higher credit card fees for specific types of merchants. Reports indicated that both companies have been interested in a 0.05% to 0.10% increase for ecommerce transactions, which could result in higher interchange fees for merchants processing commercial cards, credit cards, or large transactions.

At the same time, Mastercard and Visa will likely issue lower rates to merchants who adopt transaction tokenization. This new technology has been recognized as an effective transaction security measure.

However, the COVID-19 pandemic caused financial difficulties for many retailers. Therefore, raising fees during this period would have likely presented both companies with serious public relations problems.

Mastercard and Visa have now delayed their respective fee increases for two consecutive years. No changes are planned for 2021. However, Payment Depot notes that higher interchange rates could take effect in 2022.

Factors that affect interchange rates

Each credit card transaction carries its own interchange rate. To arrive at this figure, the issuing bank considers varied factors that affect the transaction’s risk level.

One such factor is the merchant category code (MCC). MCCs are assigned based on the type of business, and different types of businesses have different levels of risk and average transaction sizes, which are reflected in their MCC.

1. Credit card brand 

Each major credit card association determines its own interchange fees. Therefore, accepting one card brand over another may result in higher merchant costs.

Acquiring banks pay interchange fees as part of their cost structure, which helps cover the issuing banks’ expenses in processing card transactions and provides an incentive for them to offer card acceptance services.

Specifically, American Express has frequently been criticized for assessing higher fees compared to Mastercard or Visa. However, American Express now offers a program that increases the ability of small businesses to accept the company’s cards.

American Express charges merchants a “discount rate” instead of an interchange fee. However, the two terms essentially mean the same thing.

2. Transaction category 

Credit card associations further segment their interchange fees by business categories (or business types). Common business cardholder types include general merchandise, gas stations, and restaurants, among others.

As the Federal Reserve System states, transactions made via general-purpose prepaid cards have an exemption from interchange fee standards. This exemption applies even if a covered issuing bank distributes the prepaid cards.

3. Debit cards vs credit cards 

Credit card interchange rates are approximately six times as high as debit card interchange rates. Debit card transactions are less complex to process and easier to approve. Funds are taken directly from the customer’s linked bank account, so debit card transactions receive a reduced interchange rate, resulting in a lower interchange fee.

Encouraging cash transactions can also help businesses reduce interchange fees, as cash transactions do not incur any interchange fees at all.

Conversely, credit card payments involve the card-issuing bank’s extension of credit to each customer. The bank also covers the cost of the in-process transaction. The customer must later repay the bank for the transaction cost. Most credit card transactions will be approved if they do not exceed the account’s credit limit.

However, continued increases in credit card fraud have spurred banks to implement more complex security protocols. These practices are designed to put a halt to fraudulent payment system transactions.

4. Type of card owner 

Credit card associations assign different rate categories based on a card’s ownership. In this respect, individual consumers are treated differently than businesses and government agencies. The rate variations are generally based on the card owner’s ability to repay the purchase amount.

Using this rationale, a private company’s or government agency’s purchase is regarded as less risky than a typical consumer transaction. Therefore, business and agency purchases will carry lower rates.

5. Card-present vs card-not-present transactions

Merchants undertake increased risks when accepting card payments without seeing the actual card. These transactions also cause card-issuing banks to face a higher risk. Therefore, card-not-present transactions are charged a higher interchange rate (and thus higher fees).

Card-present transactions typically incur lower interchange fees compared to card-not-present transactions due to the lower risk of fraud when the customer’s card is physically present.

Ecommerce sales, along with telephone and mail order transactions, are considered card-not-present transactions. In a retail environment, this term also applies to manually keyed-in sales.

To illustrate, assume a card reader cannot recognize a worn-out magstripe card. Therefore, the sales associate must key in the numbers by hand. Fortunately, the widespread use of embedded-chip EMV cards greatly reduces the chances of this occurrence.

6. Address Verification Service (AVS)  

During each card-not-present transaction, the payment processor electronically contacts the Address Verification Service (or AVS). Ideally, the AVS verifies that the customer’s address matches the service’s billing address in the issuing bank’s database.

Payment processors will likely charge an AVS fee to perform this address verification. However, this process also qualifies the merchant for a considerably lower interchange rate. The rate savings are often greater than the AVS service fee.

7. Transaction tokenization

Merchants who tokenize their customers’ transactions may be charged lower interchange rates. To illustrate, in October 2021, Visa will begin offering reduced rates to merchants who tokenize their card transactions. Tokenization has been recognized as an effective way to improve transaction security.

8. Rewards cards usage 

Many issuing banks offer rewards cards that contain perks such as cashback on purchases or frequent flier miles. When a customer uses one of these types of cards, the merchant pays a higher interchange rate on that transaction.

Retailers who use a tiered pricing plan will be especially hard hit by rewards cards transactions. A tiered plan frequently downgrades these sales to “non-qualified” status. This downgrade results in rates that are two to three times higher than “qualified” transaction rates.

How interchange rates are calculated

Each country’s interchange rates can vary, and merchants in the US generally pay the highest rates. The process of calculating interchange fees involves determining the rate percentage and applying a specific calculation formula. Although competition among credit card associations has helped to minimize rate increases, rates have continued to rise.

Each credit card association uses its own rate percentage and calculation formula. The term “interchange qualification” refers to the categorization of a transaction to obtain its applicable rate.

To illustrate, Visa’s interchange qualification process integrates its Custom Payment Service (or CPS) into the mix. If a retailer follows specific rules, transactions can be re-qualified to a lower-rate interchange category.

Merchants’ experiences with interchange fees

Every payment processor chooses its own payment processing structure. So, each framework treats interchange fees differently.

Interchange fees affect businesses that heavily rely on card transactions by impacting their operating costs, pricing decisions, cash flow, business model, and the choice of payment processor.

Interchange-plus and membership plans

The interchange-plus and membership-based payment processing plans separate the interchange and markup portions of each transaction fee. Therefore, the merchant can determine its processor’s portion even if the interchange rate information is unavailable. An established business with a predictable monthly processing volume will generally see savings with this model.

Interchange fees can impact a business’s choice of payment processor, as different processors use different pricing models tailored to a business’s transaction volume, customer card types, and tolerance for variable costs.

Flat-rate and tiered plans

These payment processing pricing plans blend the interchange and processor’s markup components into one fee. Therefore, it is virtually impossible for the merchant to determine the issuing bank’s and processor’s respective charges. Although this method makes it easier to predict transaction processing costs, merchants often pay higher fees overall.

However, flat-rate pricing can be a good option for small businesses or seasonal merchants. Their payment processors do not typically charge monthly or annual account maintenance fees.

How to minimize interchange fees

Smaller retailers can take several steps to reduce interchange fees. Various strategies for businesses to reduce interchange fees include negotiating with payment processors, choosing the right payment processor, improving card processing practices, and regularly reviewing processing statements. Some tactics pertain to the purchase transaction while others relate to retail services. Let’s take a look at some of them:

  • Include order number and authorization ID at settlement
  • Use the Address Verification Service for every transaction
  • Settle transaction within three days of purchase
  • Ship orders within seven days after authorization

It is important to balance financial returns with the optimal customer experience when reducing interchange fees.

Finally, merchants can minimize interchange fees by avoiding chargebacks. An excessive number of chargebacks might force a merchant into the “high risk” group. This results in higher interchange rates and possible account termination.

Making the best choice

Highest Rated Payment Processor In The Market

Every small- and medium-sized business wants to obtain the best credit card processing rates. Payment Depot streamlines your credit card transactions by equipping you with the latest payment technologies and terminals. Plus, with Payment Depot, you won’t encounter hidden fees thanks to our transparent, interchange plus pricing model, ensuring you always know what you’re being charged. Contact us to get started today.

FAQs about Interchange Fees

Q: What are interchange fees?

Interchange fees are transaction fees that a merchant’s bank account must pay every time a credit or debit card transaction occurs. They cover the costs associated with processing the transaction and the associated fraud risks.

Q: How are interchange fees calculated?

Interchange fees are calculated by applying a specific interchange rate, or percentage, to the purchase total made on a credit or debit card. The specific rate depends on multiple categories and eligibility requirements associated with the particular credit or debit card in use.

Q: Who receives the interchange fees?

Interchange fees are paid to the card-issuing banks by the merchant’s bank, also known as the acquiring bank. The merchant’s account provider simply serves as a conduit for these fees.

Q: What is the typical range for interchange fees?

For credit cards, interchange fees usually range between 1.5% and 3.3% on average. For debit cards, interchange rates are approximately six times lower due to their relatively simpler transactional nature and hence, lower risk.

Q: What is the Durbin Amendment in relation to interchange fees?

The Durbin Amendment is a component of the Dodd-Frank Wall Street Reform and Consumer Protection Act that imposes a cap on debit card transaction fees. Introduced by US Senator Richard J. Durbin in 2010, this amendment reduced the previously average interchange fees from around $0.44 per transaction to $0.21 per transaction plus 0.05% of the transaction amount.

Q: Are interchange fees regulated?

Interchange fees in the United States are governed by regulations such as the Durbin Amendment. However, credit card associations such as Visa, Mastercard, American Express, and Discover independently determine their respective interchange fees.

Q: How can businesses minimize their interchange fees?

Businesses can minimize interchange fees by optimizing their transaction process, such as utilizing the Address Verification Service for each transaction, settling transactions as soon as possible, avoiding chargebacks, and using tokenization for transaction security. They may also choose to work with a trusted merchant service provider that offers competitive rates.

Q: Do interchange fees differ in various regions?

Interchange rates may vary from one country to another. Generally, merchants in the US pay the highest rates, while in Europe, the rates average around 0.3-0.4% of the transaction amount.

Q: Are interchange fees subject to change?

Some major card networks review their interchange fees annually. This could result in some rate increases along with rate reductions.

Q: What factors affect an interchange fee’s rate?

An interchange fee’s rate can be influenced by multiple factors, such as the transaction’s risk level, the card’s ownership and usage, the nature of the transaction (i.e., card-present or card-not-present), and the type of card (credit or debit).

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