The core dynamic of using money to purchase goods from a merchant has remained unchanged for hundreds of years. However, the way customers pay for their purchases has become much more complex.
With today's marketplaces becoming more integrated with digital technology, businesses must adapt to seismic shifts in consumer preferences, as well as changes in payment systems. While millions of consumers still pay with cash, the use of credit cards, debit cards, and new digital wallets like Apple Pay and Android Pay has skyrocketed in popularity in the last decade.
For instance, in one survey of more than 1,800 consumers, 84% said that a merchant should provide the ability to pay using a credit card. Meanwhile, the 2020 World Payments Report predicts that digital wallet users around the world will increase from 2.3 billion in 2019 to 4 billion users in 2024.
To accommodate these diverse payment preferences, business owners in the retail, food and beverage, travel, and hospitality industries must have the infrastructure to handle these payment processing options.
At its simplest, payment processing refers to the series of steps required to accept, authenticate, and approve transactions. This is followed by another set of steps wherein funds from the customer's credit card, debit card, or virtual wallet are transferred to the merchant through several parties responsible for facilitating the transaction.
Whether it's for a small business, restaurant, e-commerce store, or online marketplace, the fundamental steps of payment processing are the same. Transactions between the customer and merchant are automated with multiple third-party services that work together to process the customer's payment information and approve or decline the transaction on behalf of the merchant based on predetermined rules.
For instance, a credit card payment can be denied automatically if a payment processor detects that the card has insufficient funds. Conversely, if there are enough funds, the transaction is approved and the funds are moved from the customer's credit card account to the merchant's bank account.
Regardless of where a transaction happens, whether it's in the store, over the phone, or online the basic flow of payment processing will involve these three primary players-
- The Merchant
- The Customer
- The Infrastructure
- The Payment Processor, which communicates transactions through the payment processing network and works with issuing banks and the merchant account provider
- The Payment Gateway, which is the software that links stores to the processing network
The average credit card and debit card transaction involves multiple providers working together as the payment process moves from consumer to merchant and back again. Each provider does a bit of everything to not just speed up the payment process but to ensure its security as well.
Payment processors are business entities that act as mediators between banks and merchants involved in non-cash transactions. The processor is responsible for authenticating the customer's payment information and moving funds to the merchant after completing the sale.
In the few seconds it takes to approve or decline a credit/debit card payment, the processor will have done three things- check if the buyer has sufficient funds in their account, check if their card account has no restrictions, and check if the card used is valid.
Payment processors also ensure that all parties involved in the transaction, including issuing banks and credit card networks (e.g., Visa and Mastercard) receive their portion of payment processing fees.
A payment gateway is responsible for exchanging information between customers' issuing banks, merchant accounts, credit card associations, and all other parties involved in the transaction over the Internet.
In the world of e-commerce, a payment gateway can be likened to an online point-of-sale (POS) system, acting as the front-end infrastructure that allows merchants to process online transactions without physically accessing customers' payment cards.
Offline, payment gateways allow brick-and-mortar stores to accept payment methods other than credit cards, such as digital wallets like Apple Pay and Android Pay. These services are provided by software companies and bank-affiliated providers.
Businesses need a merchant account to accept credit cards, debit cards, and other non-cash payment methods in-store, over the phone, and online. A merchant account allows transaction funds to be parked before being finally transferred to the business's bank account.
Access to a merchant account involves following several regulations set by card networks. Full-service merchant account services provide merchants with a unique identification number that indicates their identity to all parties involved when processing a payment.
In exchange, merchants will have to pay monthly fees to their merchant account provider (MAP), which can make these accounts impractical for small businesses. Small companies can opt for payment service providers, which offer shared merchant accounts to multiple sellers.
Point-of-sale (POS) systems allow brick-and-mortar businesses to accept credit cards, debit cards, digital wallets, gift cards, and other card payment methods.
Unlike cash registers of the past, modern POS systems typically come with card payment terminals that securely process all payment methods and can be integrated with the business's inventory management system and seating plan.
The number of credit card payments in the US continues to grow exponentially with each passing year.
According to the Federal Reserve, the number of credit card payments in 2018 reached 44.7 billion, up 11 billion transactions from 2015. Unsurprisingly, this has put pressure on small and medium-sized enterprises (SMEs) to provide customers with the option to pay using cards from day one of operations.
While the process of accepting and approving credit cards is very complex, it can be simplified into three steps-
At the point of sale, the customer presents their credit card to the merchant. In the store, this happens by swiping, tapping, or dipping the card into the credit card terminal. Online, the customer inputs their credit card information on the checkout page.
The cardholder's information, which includes the credit card number, expiration date, purchase amount, and security code, is sent to the payment processor, which then contacts the issuing bank to authenticate the transaction.
Once the customer's issuing bank receives the authentication request, it checks whether the customer has sufficient credit in their account to cover the cost of the purchase.
The issuing bank will also perform anti-fraud checks, such as by sending a one-time-password to the cardholder via SMS. If no red flags are detected, the bank approves the transaction.
At this stage, the statements containing details of the transaction are sent to both the customer and merchant, while the funds are then disbursed to the business owner's merchant account.
At the end of every business day, the merchant sends a record of all credit card transactions that happened during the day to their merchant account provider, which then sends the details of these transactions to their corresponding credit card networks.
In turn, the credit card network matches each transaction with its associated issuing bank. Only then are the funds finally moved to the business's bank account.
Debit card transactions follow the same processing flow as credit card payments. However, because the issuing bank no longer has to issue a credit to cover the cost of the customer's purchase, the authentication process is much simpler. As long as the cardholder has sufficient funds in their bank account and no red flags are raised, the transaction will be approved.
Because of this simpler process, merchants can expect the fees for debit card payments to be lower than credit card transactions. However, there is a catch.
Businesses looking to accept debit card transactions must have a PIN pad attached to their card payment terminal or POS. This allows customers to authenticate their debit card payments by inputting their card's Personal Identification Number (PIN).
This bypasses the standard authentication process and incurs the lowest processing fees. Without a PIN pad, debit card transactions will be processed the same way as credit cards and the higher fees will be applied.
A digital wallet or mobile wallet is a software-based platform that stores digital versions of a customer's debit card or credit card information. These platforms typically use the near-field communication (NFC) technology found in devices like the iPhone and Android smartphones to enable in-store purchases.
NFC refers to communication protocols for transmitting information between electronic devices over near distances (around 4cm or less). With a digital wallet, smartphone users can simply tap their device on an NFC terminal to make a purchase. In this sense, the phone itself behaves like a debit or credit card.
With so many business entities and infrastructure providers involved in processing card payments and digital wallet transactions, it's not surprising that everyone charges fees of some kind.
Businesses can expect to pay fees to the issuing bank, the credit card network, the merchant account provider, and the payment gateway. Generally speaking, businesses can expect to pay four types of fees-
- Interchange Fee - A percentage of the transaction amount paid to the issuing bank.
- Assessment Fee - A percentage of the transaction amount paid to the card network.
- Percentage Fee - Charged by merchant account providers.
- Authorization Fee - Charged by payment processors for every transaction processed.
Furthermore, there may be pricing schemes offered by these players to consolidate their fees into a single rate.
- Flat-rate - Merchants pay a fixed percentage for all transactions, regardless of the actual costs. All fees are rolled into a single rate.
- Interchange Plus - Merchants pay a fixed fee, which is referred to as a markup, on top of the interchange fee.
- Tiered Pricing - Also known as Bucket Pricing, this model groups the hundreds of different interchange rates into three pricing tiers- qualified, mid-qualified, and nonqualified. However, this model is less transparent because processors have the discretion to change these rates and bucket prices whenever they like.
Whether a business is expanding its accepted payment methods or branching out into eCommerce, it's important to understand how electronic payments are processed. This knowledge allows business owners to make informed decisions when choosing their providers and creating a plan that works best for their organization.