What Is Pre-Authorized Debit and How Does It Work?

What Is Pre-Authorized Debit and How Does It Work?

In today’s highly competitive marketplace, companies that can generate recurring income from one customer have an advantage over their competitors. After the set-up process, these businesses will enjoy recurring payment income with no additional effort. They won’t have to worry about missed monthly payments from distracted or cash-crunched customers.

For perspective, a Mercator Advisory Group February 2022 report says these frictionless (or effortless) payments are a significant income source. By 2025, the United States recurring payments market is predicted to produce $830 billion in aggregate transaction volume. Subscription payments comprise a substantial portion of the lucrative U.S. recurring payments market.

Pre Authorized Debit_Recurring Payments Market_Infographic

What Is Pre-Authorized Debit?

The term “Pre-authorized Debit” (or pre-authorized debit agreement) is a payment method that is gaining increasingly widespread use. Here, a merchant (or biller) is authorized to debit a customer’s bank account on a specific date. The funds are quickly transferred from the originator’s bank account directly to the small business merchant’s account. In some ways, it’s like the reverse of a direct deposit for an employee’s paycheck.

A pre-authorized debit agreement (or PAD agreement) sets the stage for seamless recurring payments. With this agreement on file, a customer can make a pre-authorized debit payment (or PAD payment) for insurance premiums.

Customers can also make utility bill payments, fitness center membership payments, or streaming service payments via the PAD payment processing method. Pre-authorized debits can also help customers avoid last-minute credit card or debit card payments over their phones.

How did pre-authorized debit originate?

Pre-authorized debit payments likely evolved out of businesses’ need to obtain recurring payments from customers. Prior to offering this automatic payment option, merchants probably encountered customers’ missed bill payment excuses. A specific customer’s bank account may have contained insufficient funds. This made it tough to collect funds via their financial institution.

Instead of chasing monthly customer payments, a PAD agreement enables the business to effortlessly collect an on-time payment. A one-time pre-authorization sets up a recurring funds transfer that continues until the customer cancels it via written notice.

What Is the Purpose of Pre-Authorized Debit?

The pre-authorized debit payment method is designed to benefit a small business and its customers. First, after a customer completes a pre-authorized debit form, a small business can easily receive funds for recurring payments.

This means the merchant doesn’t have to undergo the time (and expense) of billing a customer every month. In addition, the merchant doesn’t need to rely on the customer to make each timely payment.

Concurrently, a PAD payment system serves two purposes for customers. First, customers can avoid late payment fees that can add up over time. In addition, customers can lessen the need for online banking transactions. In turn, this helps them to streamline their personal finances.

However, pre-authorized debit payments do have two potential downsides. First, there is always a minimal chance of billing errors. Although correctable, they take time to resolve. This defeats the purpose of the “set it and forget it” PAD structure.

Customers must also ensure their account contains enough money to cover their pre-authorized debits. Otherwise, they will occur insufficient funds fees for the PAD payment and possibly other expenses.

Types of Pre-Authorized Debit

Payments Canada is a non-profit entity that regulates and oversees the Canadian payment and settlement system. This respected organization names four types of pre-authorized debits.

  • Business PADs: Used to make B2B payments between a small business and its suppliers, distributors, or franchisors and franchisees
  • Personal PADs: Used to make an individual’s recurring payments for goods or services
  • Funds transfer PADs: Used to transfer funds from a bank account to a second account at another bank or financial institution
  • Cash management PADs: Used to move funds between two accounts under the same company umbrella (recurring transfers to a savings account)

How Does Pre-Authorized Debit Work?

The pre-authorized debit payment method enables a merchant to debit a customer’s bank account on a recurring basis. For perspective, the PAD payment method functions like automatic credit card payment processing that are applied to a customer’s big-ticket purchase.

To create a PAD agreement, the customer completes the pre-authorized debit form that contains the details of the recurring transaction. They’ll enter their contact information along with account information and banking information. This includes a transit number (or routing number), account number, and often a void check.

The customer also agrees to have a certain amount deducted from their account on a predetermined date. With a recurring invoice, that deduction will take place like clockwork. A PAD payment is also highly secure. Each financial institution encrypts the transaction details as it would with a bank-to-bank transfer.

Each financial institution has its own payment processing cycle. Although most PAD payments will be settled very quickly, some payments could take a few business days. Ideally, no unauthorized debits (such as accidental double charges) will occur. In that case, the customer would ask for an account reimbursement.

How Can Businesses Implement Pre-Authorized Debit?

Pre Authorized Debit_Agreement Provisions_Infographic

Implementing a pre-authorized debit option is a simple process. First, the merchant must generate a pre-authorized debit agreement that contains the following provisions:

  • Contact information: The agreement must clearly display the merchant’s contact information.
  • Payment timing: The agreement must state the payment withdrawal frequency. Weekly, monthly, or annual are common choices. Alternatively, the merchant can state that the withdrawal will take place on a certain date each month.
  • Payment amount: This can be a fixed or variable dollar figure. For a fixed amount, the agreement must state the monthly deduction amount. For a variable amount, the merchant must state that the payment will vary each month. They must also provide at least 10 days’ notice of the amount to be deducted.
  • Payment dispute protocols: The agreement should include instructions about how customers can dispute a pre-authorized debit.
  • Payment cancellation instructions: The agreement should clearly state the steps involved in canceling a future PAD payment. Some merchants may provide a cancellation form.

When the customer signs the agreement, they are allowing the merchant to make a recurring withdrawal per the agreement’s instructions. The customer should ensure that they have sufficient funds to cover each transaction.

Partnering with a Respected Payment Processor Is Key

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Merchants who work with a seasoned payment processor can receive needed support for seamless recurring payment acceptance. Payment Depot’s small business-friendly model integrates membership-based pricing and no laundry list of fees (including cancellation fees). And, the company regularly gains small business client praise for its excellent customer service. Contact us today to learn more.

Pre-Authorized Debits: FAQs

Pre-authorized debits provide a streamlined way to make recurring payments. However, two issues may impact this payment method’s effectiveness.

When does a pre-authorized debit rejection occur?

A pre-authorized debit rejection occurs when the merchant is unable to complete the scheduled PAD payment. This may occur when the customer has insufficient funds in their bank account. In this case, the merchant has 30 days to reattempt to debit the account.

Can customers get refunds for unauthorized debits?

If an unauthorized debit occurs, the customer usually has 90 days from the transaction date to request their funds’ return. They may receive the payment back if it was processed on the wrong date or was for an incorrect amount. If the customer had already canceled the agreement, they could also receive their money back.

Contact us today to learn more about payment authorization process.

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