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October 7, 2014

How Payment Processing Works

Since most merchants accept credit cards for their business, it’s important to know how payment processing works. You may be wondering why you have to pay certain rates and what these fees are for. You may also want to know how you can get the best processing rates to lower your expenses. We’ll explain all of that so you have a better understanding of the credit card processing world.

Know the Players Involved

First of all, it’s important to know all of the players involved in the costs of accepting credit cards.

  • Issuing banks

Issuing banks are the entities that provide the actual credit card to customers. The issuing bank extends a line of credit to the consumer and shares the liability for non-payment by a merchant.  The large card-issuing banks, Wells Fargo, Chase, Citibank, etc work with the card brands to determine “interchange fees“.

Interchange fees are where most of a credit card transaction’s expense comes from. These rates are the same for all credit card processors, no matter who processes the transaction as this is public information which vary by card type and transaction type.

  • Acquiring Banks/Processor

Acquiring banks maintain merchant accounts for businesses so they can accept credit cards. Acquiring banks collect a small fee for each credit card transaction and play a minimal role in the overall cost of payment processing. Acquiring banks also assume much of the risk in the credit card processing network because merchant accounts are considered a line of credit.

It’s important to understand that when you accept credit card payments, you’re actually borrowing money. When the acquiring bank/processor transfers cash to the merchant, it’s assuming the risk that there will be a chargeback.

Despite that risk, the acquiring bank/processor will put the funds in the merchant’s account within a day or so after transaction is reported. The acquiring bank sees this as a loan. That’s why when you apply for merchant services, processors evaluate your ability to borrow the amount that your business generates in credit card transactions.

  • Card Brands/Associations

Visa, MasterCard and Discover are card brands. Their primary responsibilities are to govern the members of their associations, establish interchange fees and qualification guidelines, act as the mediator between issuing and acquiring banks, maintain and improve the card network and their brand, and of course, make a profit.

American Express acts as both the issuing and the acquiring bank and charges fees directly to the merchant service provider who will administer the transaction so that a merchant can process American Express transactions directly through them.

The card brands & associations also charge fees called “Dues & Assessments”that are uniform across the industry; all processors pay the same amount. They account for about 2-3% of the overall expense and are a fixed component of credit card processing costs.

  • Merchant Service Providers (MSP)

A merchant service provider acts as a vehicle for all communication and relationships between the merchant, card associations, processors, and merchant bank.

Merchant service providers are also known as Independent Sales Organizations (ISOs), who resell the products and services of one or multiple processors. For example, Chosen Payments is an ISO. They are “Third-Party Processors” and sometimes offer their own value-added products. There are basically two types of ISOs: banks and non-banks.

  • Banks – local community banks, large regional banks, national banks and credit unions that have entered the merchant service provider business. Most banks are ISOs, although they may brand their services so it’s difficult to tell whether or not they are the actual processor.
  • Non-banks – this group of ISOs range from high-quality providers to smaller firms that are in and out of business trying to make a quick buck. The majority of complaints from merchants are usually from dealing with an unscrupulous, rogue sales agent rather than a reputable ISO. Unfortunately, this has given the MSP and processing industry a bad reputation.

A common misconception is that banks are direct processors that offer better pricing. Unfortunately, most banks outsource their merchant services to big processors, such as First Data, and pay the same rates for the services as MSPs do. For example, Chosen Payments is contracted by many banks nationwide to market merchant services on their behalf. Thus there are more hands in the cookie jar.

Banks also price merchant services higher since it’s not their primary business model (making loans is actually how they make their money) and have fewer resources dedicated to customer service in that area. So don’t expect to get the lowest possible deal from your local bank.

Cost considerations for MSPs include:

  • The level or service you receive (24 hours/365 days a year vs. bank hours)
  • How chargebacks are handled
  • How security is managed
  • Value-added services
  • Direct ISO or agents (are there additional parties involved between agent and acquirer?)
  • Reliability (multiple flexible processing platforms and data-center redundancy for maximum uptime)
  • Who is the acquiring bank
  • End to end relationship

How Does It All Work?

Merchant service pricing can be explained with a simple retail vs. wholesale analogy:

The merchant is the customer and the Merchant Service Provider is the retail business.

The MSP receives a product from a wholesaler/distributor called the acquiring bank who received their product from a manufacturer called the issuing bank that made their products from parts from the card brands.

Thus, the rate that you pay to process a credit card transaction is a combination of base costs and markups called “merchant discount”. Think of merchant discount as the retail price of credit card processing, base costs as raw material expenses (interchange), and the markup as production costs.

Base costs should account for the largest portion of expense (about 75% – 80%) followed by the markup (about 20% – 25%).

Where Does Your Money Actually Go?

The majority of your credit card processing expenses are called “interchange fees” which are paid to card-issuing banks.Your processor and/or MSP don’t see any revenue from interchange.

Interchange is the transfer rate exchanged between the acquirer and issuer each time a branded card (Visa, MC, AmEx, etc.) is used.

It can vary significantly based on a series of complex requirements, including:

  • Your business type
  • The card brand  (Visa, MC, AmEx, etc.)
  • The type of card presented by the consumer (credit, debit, rewards, corporate, etc.)
  • The amount of the sale
  • What type of data you enter into your terminal or software (AVS, tax info, etc.)
  • If you swipe or manually key in the sale
  • If the authorization, transaction and settlement dates fall within established tolerances (usually within 24 hours)

Interchange comprises roughly 125 separate categories with more than 700 different rates and is adjusted twice a year, in Spring and Fall.

For example, if you swipe a Visa Individual Rewards Card for $100, there will be an interchange fee of $100 x 1.65% + $0.10, which equals $1.75.  It costs you $1.75 to accept that transaction before any processor fees are added in. If you key-in that same card, the interchange changes to $100 x 1.95% + $0.10, which equals $2.05.

Interchange costs are public information and can be found on the associations’ respective websites.

MasterCard Interchange: http://www.mastercard.com/us/merchant/pdf/Merchant_Rates_April_2014.pdf

Visa Interchange:

http://usa.visa.com/download/merchants/Visa-Interchange-Reimbursement-Fees-April-2014.pdf

Part of interchange also includes “Association Dues and Assessments”. Dues & Assessments are processing fees paid to the card associations to finance their roles in operating the network, setting rules, setting pricing, research and development, and marketing/branding.

Acquirer/Processor Fees

Processor fees are paid to an acquiring bank or organization and those fees represent 20-30% of your total fees. They pay for:

  • Communication Costs (dial or internet)
  • Customer Support
  • Technical Support
  • Risk/Underwriting
  • Statements/Billing
  • Product Development
  • Other Overhead Expenses

Markups

Markups are any rate or fee beyond interchange fees and assessments, as well as acquirer/processor fees. Markups mostly consist of the merchant service provider’s charges plus any costs incurred from gateway, equipment or software providers.

Markups are the only non-fixed cost associated with credit card processing, and this is the only area where merchant costs are pliable.

Processing markups typically account for 10-30% of gross processing costs. So when negotiating your credit card processing fees you want to focus on the mark up above cost as that is the only place the ISO makes money.

To put things into perspective, if a merchant processes $100,000 in a given month and pays approximately $2,700 in total fees, the breakdown may look like this: $2,300 – issuing banks, $175 – card brands, $75 sponsor banks, $150 ISO. Keep in mind the person you speak to on the phone and who you actually do business with is the ISO.

It is important to understand this so you and your staff don’t spend too much time trying to negotiate an impossible task. Generally speaking if you find out what your “basis point mark up above interchange” is then that is where you have room to negotiate.

However, if an ISO is willing to work for much less than $100-$200 per month in gross profit on your account (assuming the 100k/per month example), I would question the service level as well as the stability of the firm.

No matter what business we are in we all must make a profit one way or another. And like all else in life it does not always come down to cost, we get what we pay for!

Hopefully understanding this will help eliminate some of the headaches that come with accepting credit cards and reviewing your monthly merchant statements.

 

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