How Do Credit Card Transactions Work?

Credit card transactions are approved in seconds, and the next thing you know, digital and physical goods are being shipped all around the globe. However, there’s a lot that goes on in the few seconds it takes to approve a transaction and in the day or two that follow. If you’re a business owner who is thinking about accepting credit card payments, being familiar with how a credit card transaction works will help you to make the most of the system and avoid overpaying on fines and fees.

The Parties Involved in a Credit Card Transaction

There are up to six parties involved in every credit card transaction, depending on the card brand used and whether it’s a credit or debit card. For the sake of simplicity, we’ll focus on credit cards.

The parties in credit card transactions are:

• The cardholder. This is the owner of the credit card account, whose name appears on the front of the card. The cardholder makes purchases.

• The merchant. This is the e-commerce or retail shop business owner who charges the cardholder in exchange for goods and services.

• The payment processor. This is a third-party business that liaises between the merchant and the acquiring bank. The main kinds of payment processors are merchant aggregators (like PayPal) and dedicated merchant account providers (like Unicorn Group).

• The acquiring bank. This is the bank that processes credit and debit card transactions on behalf of the merchant. The acquiring bank or merchant bank is different from the merchant’s business bank account provider and mostly works behind the scenes.

• The credit card network. The most popular card networks worldwide are Visa, MasterCard, American Express and Discover. Visa and MasterCard work in conjunction with issuing banks, acquiring banks and payment processors. American Express and Discover process their own card payments.

• The issuing bank. This is the bank that issues the customer’s credit card and represents the customer’s interests in the case of a disputed charge.

The Credit Card Processing Lifecycle

Now that we know who’s involved in the credit card transaction process, let’s take a look at the lifecycle of a credit card transaction:

• Authorisation request. This is the up-front part of a credit card transaction, in which the cardholder submits their credit card details to the merchant and the sale is either approved or declined.

• Authentication. This includes any background checks performed by the merchant, including address matching, card verification value matching, IP address checks and reverse lookups. If these fail, the transaction is blocked.

• Batch processing. This refers to the merchant’s daily task of submitting approved transactions to the payment processor or acquiring bank for clearance and settlement.

• Clearance and settlement with the acquiring bank. The acquiring bank checks and clears the approved transactions and requests payment from the issuing bank, which transfers the funds to the acquiring bank.

• Merchant settlement or funding. The acquiring bank transfers the funds—minus transaction fees—to the merchant’s business bank account.

• Repayment. The customer repays the issuing bank for credit card purchases, according to their agreement with the bank.

• Chargebacks and returns. If the customer has concerns about a charge or a product that was delivered, he or she can request a refund or force a chargeback through the issuing bank. Businesses typically offer a refund window of 30 days from the date of purchase. Chargebacks can be issued as late as 120 days after a purchase is made.

How Credit Card Transactions Work in Detail

Authorisation Request and Authentication

1. The customer enters his or her credit card payment details into the form provided by the merchant (for e-commerce) or swipes, inserts or taps the card against the card reader (for in-person sales).
2. The payment gateway (in e-commerce) applies fraud filters and blocks or flags the transaction if the authorisation request violates its pre-set rules. For example:
   a. The billing and shipping address don’t match.
   b. The card is an international card that has not been pre-approved
   c. IP checks and reverse lookups indicate possible identity theft.
   d. The card number has been used to make repeated purchases in a short amount of time.
3. If the request passes the on-site fraud filters or a POS system without fraud filters is used, the payment gateway forwards the authorisation request to the merchant’s acquiring bank via the payment processor.
4. The acquiring bank forwards the authorisation request to the appropriate credit card network for routing to the issuing bank. The credit card networks are VisaNet (for Visa) and BankNet (for MasterCard).
5. The credit card issuer receives the request and checks whether:
   a. The card is valid
   b. The card has not been reported lost or stolen
   c. There are sufficient funds to cover the purchase
   d.If the merchant uses AVS (address verification service for credit card processing), the issuing bank also checks whether the billing address and address on file for the card match.
6. The cardholder’s issuing bank returns an approved or declined message for the transaction through the same network in reverse (issuing bank – card network – acquiring bank – payment processor – merchant), along with a code if AVS was requested. Depending on the code displayed, the merchant can choose to approve or deny the transaction.
7. If the transaction is approved, the customer receives a “success!” message and the funds are deducted or displayed as “pending” in their bank account. If the transaction is denied, a “denied” message displays and the customer may be instructed to contact his or her bank.

Batch Processing

At the end of each day, the merchant submits all of the day’s approved transactions for processing. If any transactions are on hold or flagged for review, the merchant can check each one, view the details of the hold (such as an AVS code) and decide whether to allow or deny the transaction before submitting the batch for clearing and settlement.

Depending on the acquiring bank, there is usually a cut-off time for batching, after which transactions submitted will be processed on the next business day. Merchants who want their funds sooner should submit the day’s batch before the cut-off time.

Clearance and Settlement (Acquiring Bank)

This is the point at which money actually changes hands.

1. The acquiring bank checks the transaction details and requests settlement from the cardholder’s bank.
2. The cardholder’s bank routes the money to the acquiring bank, minus interchange fees and the card network’s assessment fee.
3. If it was previously marked as pending, the purchase amount is now deducted from the cardholder’s credit card balance.

Settlement (Merchant)

After a holding period (usually one business day), the acquiring bank releases the funds to the payment processor, who deducts their markup fee and deposits the funds into the merchant’s business bank account. The money is usually available in the merchant’s account around two business days after the original transaction.

Credit Card Repayment

In the pre-agreed timeframe, the customer repays their issuing bank for purchases made with their credit card, plus fees and interest for late repayments. Repayments are usually made each month when the customer receives their credit card bill.

Chargebacks and Returns

Ideally, all purchases would be final. However, customers sometimes request a refund or force a chargeback for a variety of reasons:

• The customer was a victim of credit card or identity theft.
• The product never arrived.
• The wrong product was shipped.
• The product was damaged.
• The product was not as advertised.
• A clothing item didn’t fit.
• The customer had a change of mind.
• The customer is committing friendly fraud.

In the case of a refund request, the merchant instructs the acquiring bank to repay the customer’s credit card. In the case of a chargeback, the issuing bank forces a reversal of the transaction process and is paid out by the acquiring bank. In both cases, the amount of the refund or chargeback (plus fees and penalties in the case of a chargeback) will be deducted from the merchant’s next payout to cover the acquiring bank’s costs.

Fees Charged for Credit Card Transactions

All credit card transactions come with processing fees, which are paid by the merchant. As mentioned, processing fees are charged by the issuing bank, card network and credit card processing company. While the assessment fee (charged by the card networks) and interchange fees (charged by issuing banks) are usually fixed, the markup charged by the payment processing company can often be negotiated.

The most common pricing structures offered by credit card processors include:

• Interchange-plus
• Tiered pricing
• Fixed transaction fees
• Interchange-plus with a monthly subscription fee

For high-risk merchants, credit card processing companies often charge higher fees and may also require a rolling reserve in case the merchant becomes insolvent and isn’t able to repay money owed to the acquiring bank for refunds and chargebacks. However, if a high-risk merchant account is the only way you can accept credit card payments, it’s usually worth the higher fees in order to continue accepting credit card payments.

How to Reduce Credit Card Processing Fees

If you’re a merchant and you’re looking to accept credit card payments or save money on processing fees, there are several things you can do:

1. Analyse your monthly merchant statement to find out what you’re being charged and how much you’re paying in fees.
2. Talk with your payment processor to see if you can negotiate a better deal, for example, interchange-plus instead of tiered pricing or a lower markup once you reach a certain processing threshold.
3. Reduce your chargeback ratio by improving your in-house processes, offering a no-hassle returns policy and choosing a payment provider with merchant services that protect you, including chargeback mitigation tools.
4. Follow the terms of your high-risk merchant account (if applicable) and switch to a regular merchant account as soon as you can.

Knowledge is Power!

Knowing how credit card processing works can help you, as a merchant, to prevent fraudulent transactions before they occur, prevent chargebacks, get paid out faster and reduce your processing fees.

If you think you’re paying too much or waiting too long for settlement, it’s worth looking around for a different merchant account provider. The savings over time could be huge!