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.  

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 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.

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. 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.

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.

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.

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).

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. 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.

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.

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.

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.

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).

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. 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-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.

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 minimize interchange fees. 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

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

Every small- and medium-sized business wants to obtain the best credit card processing rates. At the same time, it’s important to work with a company that regards merchants as valued partners.

Payment Depot offers the best of both worlds. The company’s membership-based pricing structure and wholesale rates offer an affordable package to customers on a budget. 

Payment Depot is also known for its stellar customer service. Contact our award-winning support team today to learn how you can save up to $800 per month in credit card processing costs.