Credit cards are so ubiquitous in modern society that we hardly think about them at all. We just swipe and take our purchases and leave. It may not cross our minds that there’s a system hard at work behind the scenes making sure everything runs smoothly. That system is credit card processing, and, while it has a lot of moving parts, it’s really very straightforward. So, what is credit card processing and how does it work?
What is Credit Card Processing?
Credit card processing includes all of the mechanics that make a credit purchase work, from when the cardholder swipes their card to when the money shows up in, or is removed from, your bank account. There are a lot of players involved in the process, so let’s go through them all.
Learn More: How to Accept Credit Card Payments
Who Is Involved in Credit Card Processing?
This is the most obvious role: the cardholder is the person who has the card and is using it to make a purchase. The card may be a debit or credit card–both are considered as part of credit card processing–and they receive the card from an issuing bank.
Cardholders are discussed in two different types: a transactor, which is someone who pays down their full balance every month, and a revolver, which is someone who pays some of the balance and the rest of the balance accrues interest. While there are few people who are always a transactor or always a revolver, these terms are used in the industry.
The merchant is any business that sells goods or services, but in this case the only merchants we’re referring to are the ones who accept credit cards. A merchant’s ability to accept credit cards is referred to as a merchant account.
The acquiring bank is the merchant’s bank–the bank that the merchant contracts with to create and maintain their merchant account. These banks are registered members of the credit card associations (Visa and Mastercard). This bank will provide the merchant with the equipment and software they use to receive credit card payments, and they will handle any customer service issues that come up during the course of business. The acquiring bank will deposit the funds from a credit card sale into the merchant’s account.
The acquiring bank will receive the payment authorization request from the merchant and then connect with the issuing bank. We’ll talk more about the authorization and authentication process below.
Often, acquiring banks use third party independent sales organizations (ISO) and membership service providers (MSP) to run the day-to-day operations of the merchant accounts.
This is the ISO or MSP mentioned above. The processor will provide some service or device that lets merchants accept credit cards, and sends information about the payment details to the credit card network.
This is the bank that issued the credit hard, or the cardholder’s bank. It receives the payment authorization request and either approves or denies. The issuing bank will pay the acquiring bank for the purchases that the cardholder makes. The cardholder then pays their bill to the issuing bank, per the credit card agreement.
These associations (such as Visa, Mastercard, Discover, and American Express) are not banks and don’t issue credit cards or handle merchant accounts. Instead, they are an association that makes rules regarding the use of their cards, and are an organization that oversees the credit card community and the banks they serve.
Credit card associations make rules regarding interchange fees and qualification guidelines, provide arbitration between issuing banks and acquiring banks, maintain the credit card network, and promote their brand.
How Does Credit Card Processing Work?
Credit card processing works in a basic three step process of authorization, authentication, and then clearing and settlement. While credit cards can be used in any number of places, including stores, online outlets, e-commerce, wireless terminals, and phones, they all go through this same process. The entire credit card process only takes a few seconds–every time you make a purchase with your card it goes through this entire process in two or three seconds.
Here is an explanation of how the credit card process works for a standard brick-and-mortar store.
In this beginning stage or the process, the merchant (as described above) must get authorization from the issuing bank (also described above) to make the sale. This happens in the following steps:
- The cardholder gives their credit card to the merchant at the time of sale.
- When the customer’s credit card is swiped in the point-of-sale (POS) terminal–a credit card machine, software, or gateway–the cardholder’s credit card information is sent to the acquiring bank (or the acquiring processor).
- The acquiring bank or processor receives the information and then reroutes it to the information on to the appropriate credit card network.
- The credit card network requests payment authorization from the issuing bank. This request includes the credit card number, expiration date, billing address (for the Address Verification System AVS validation), card security code (or CVV), and payment amount.
In this second stage, the issuing bank check to make sure that the credit card is being used properly and that it is being protected from fraudulent activity.
- The issuing bank receives the request for payment.
- The bank checks either the AVS, the CVV, CVV2, CVC3, or CID. This makes sure that it isn’t being used fraudulently.
- The bank verifies that the cardholder’s account has enough funds available.
- The issuing bank places a hold on the cardholder’s account for the amount of purchase. (The funds are not immediately transferred from issuing bank to acquiring bank.)
- The merchant’s POS terminal receives the approved authorization. This response code is stored in a batch file awaiting a settlement, typically at the end of the day.
Clearing and Settlement
The final step of credit card processing is the clearing and settlement. This takes place after the authorization and authentication.
- The merchant sends the batch of authorizations to the acquiring bank or processor, usually once per day.
- The processor receives the authorizations and submits the batch to the card association networks.
- The processor divides the authorizations up and sends each to its individual issuing bank.
- The issuing bank transfers funds, except for retaining an interchange fee, which is shared with the credit card network. This takes place usually within 24 to 48 hours of each transaction.
- The credit card network sends the acquiring bank and processor their share of the funds.
- The acquiring bank deposits the money in the merchant’s account, minus a Merchant Discount Rate.
- The cardholder receives their statement and pays their bill.
Where Do Credit Card Processing Fees Go?
There are several fees that are charged on credit card purchases. There are many moving parts in the process and so many different places get a cut of the fees.
To the merchant, the fee will appear as a standard Merchant Discount Rate, which is the percentage of the total bill that will be deducted. This is typically between 1.79% and 2% of the total. (So, if the Merchant Discount Rate was 2% and a cardholder bought something for $100 with a credit card, the merchant would receive $98 deposited in their account.)
That 2% is split up into several different pieces, which are interchange fees, assessment fees, and account provider fees.
The issuing bank receives the largest portion of the fees, as an interchange fee. (This is the bank whose logo appears on the card: Wells Fargo, Chase, Bank of America, etc). This charge is typically 1.75% + $.10. This fee is charged to the acquiring bank, but is passed on as part of the Merchant Discount Rate.
These are the fees that go to the credit card association (Visa, Mastercard, etc.). These fees are typically between 0.11% and 0.095%.
Account Provider Fees
The final bit of the 2% Merchant Discount Rate goes to the acquiring bank and processor. This is usually around 0.07%.
What Happens When A Credit Card Gets Declined?
The final thing to mention when talking about credit card processing is what happens when the process gets interrupted. There can be several reasons why a credit card is declined, and it’s not always because there are insufficient funds. When the card gets declined, the POS terminal will receive a code explaining the reason, but often aren’t clear.
Some of the reasons a card will get declined are in incorrect card number (if being entered into a computer) or incorrect date; an expired card; insufficient funds; technical issues with the processing; fraud prevention measures, such as the cardholder making an international purchase, making a purchase from a location that is not near their home, or many purchases made in a short amount of time.