What Is Credit Card Processing & How Does It Work?

Credit card processing is what happens behind the scenes when you make a purchase using your credit card. Multiple parties, from the merchant and payment processing company to the credit card network and the card’s issuer, are all involved in validating the card and charging the purchase. The entire process, from the time you insert your card, tap it or submit your info online to when the transaction is completed, only takes a few seconds.

Although being familiar with the credit card transaction process may not seem useful to the average consumer, it actually gives you worthwhile insight into how your card works and just how many companies are really involved in your purchases. What’s more, knowledge of the credit card transaction process is extremely important for small business owners, since payment processing is one of the biggest costs that merchants have to deal with.

How Does Credit Card Processing Work?

Credit card processing includes three major steps. First comes authorization, which basically requests your card’s details and gets permission for the transaction from the issuer and network. Next up is authentication, which validates that the actual cardholder is the one making the transaction and confirms there’s enough available credit for the purchase. Finally, the transaction gets cleared and settled, and it appears on the cardholder’s and merchant’s financial statements. We’ll break down these steps in more detail below.

Authorization

In the authorization stage, the merchant must obtain approval for the purchase from the bank or credit union that issued the card.

1. The cardholder presents their credit card to the merchant for payment at a point of sale (POS) terminal or enters their credit card information online.

2. The customer’s credit card details are sent to the acquiring bank (the bank that processes payments for the merchant) via an internet connection or a phone line.

3. The acquiring bank or processor forwards the credit card details to the credit card network that the customer’s card is on.

4. The credit card network clears the payment and requests payment authorization from the bank or credit union that issued the card. The authorization request includes the following:

• Credit card number
• Card expiration date
• Billing address — for Address Verification Service (AVS) validation
• Card security code
• Payment amount

Below is an illustration of the authorization process, showing all the different parties the request passes through.

Authentication

In the authentication stage, the issuing bank verifies the validity of the customer’s credit card using fraud protection tools such as the Address Verification Service (AVS) and card security codes.

1. The issuing bank receives the payment authorization request from the credit card network.

2. The issuing bank validates the credit card number, checks the amount of available funds, matches the billing address to the one on file and validates the card’s security code.

3. The issuing bank approves (or declines) the transaction and sends back the appropriate response to the merchant through the same channels: credit card network and acquiring bank or processor.

4. Once the merchant receives the authorization, the issuing bank will place a hold in the amount of the purchase on the cardholder’s account. The merchant’s POS terminal will collect all approved authorizations to be processed in a “batch” at the end of the business day.

5. The merchant offers the customer a receipt to complete the sale.

In the graphic below, you can see how authentication moves from the issuing bank all the way back to you, the opposite direction of the authorization process.

Clearing & Settlement

In the clearing stage, the transaction is posted to both the cardholder’s monthly credit card billing statement and the merchant’s statement. It occurs simultaneously with the settlement stage.

1. At the end of each business day, the merchant sends the approved authorizations in a batch to the acquiring bank or processor.

2. The acquiring processor routes the batched information to the credit card network for settlement.

3. The credit card network forwards each approved transaction to the appropriate issuing bank.

4. Usually within 24 to 48 hours of the transaction, the issuing bank will transfer the funds less an “interchange fee,” which it shares with the credit card network.

5. The credit card network pays the acquiring bank and the acquiring processor their respective percentages from the remaining funds.

6. The acquiring bank credits the merchant’s account for cardholder purchases, less a “merchant discount rate.”

7. The issuing bank posts the transaction information to the cardholder’s account. The cardholder receives the statement and pays the bill.

Check out the graphic below for an easy-to-follow illustration of the clearing and settlement process.

Parties Involved in Credit Card Processing

Cardholder

The person who owns the credit card initiates the transaction in the first place.

Merchant

This is the store or vendor who sells goods or services to the cardholder. The merchant accepts credit card payments. It also sends card information to and requests payment authorization from the cardholder’s issuing bank.

Acquiring Bank/Merchant’s Bank

The acquiring bank is responsible for receiving payment authorization requests from the merchant and sending them to the issuing bank through the appropriate channels. It then relays the issuing bank’s response to the merchant.

Acquiring Processor/Service Provider

This third-party entity is sometimes an arm of the acquiring bank. A processor provides a service or device that allows merchants to accept credit cards as well as send credit card payment details to the credit card network. It then forwards the payment authorization back to the acquiring bank.

Credit Card Network/Association Member

These entities operate the networks that process credit card payments worldwide and govern interchange fees. Examples of credit card networks are Visa, MasterCard, Discover and American Express. In the transaction process, a credit card network receives the credit card payment details from the acquiring processor. It forwards the payment authorization request to the issuing bank and sends the issuing bank’s response to the acquiring processor.

Issuing Bank/Credit Card Issuer

This is the financial institution that issued the credit card involved in the transaction. It receives the payment authorization request from the credit card network and either approves or declines the transaction.

Credit Card Processing Fees & Costs

For the convenience of their customers, most merchants accept credit cards as payment. But you may have wondered why some merchants will accept only cash or require a minimum purchase amount before allowing the use of a credit card. The reason is that merchants must pay a price to accept credit card payments. Therefore, most will seek the cheapest credit card processing rates or mark up the prices of their products so customers’ payments can absorb the card-processing cost.

Having a minimum purchase amount also prevents merchants from losing too much money on cheap items with thin profit margins. For example, it may not be worth it for a mom and pop shop to pay the processing fees on items that cost less than $10 when they’re only making a few dollars per sale to begin with.

Depending on the type of merchant and through which platform a good or service is delivered (e.g., at the retail store, through e-commerce or by phone), credit card processing rates will vary. They usually are charged as flat fees, per-transaction fees or volume-based fees. For the purpose of this guide, we’ll only go into the major costs.

Merchant Discount Rate

Merchants pay this fee for accepting credit card payments and receiving service from acquiring processors. It’s usually between 2% and 3% (online merchants pay the higher end) — to as much as 5% — of the total purchase price after sales tax is added. Also known as a discount fee, this rate comprises several components: the interchange fee, assessments, and markups.

1. Interchange Fee

The acquiring bank and acquiring processor pay this fee to the issuing bank. It is market-based and set by each credit card network (except American Express). Visa and MasterCard, for instance, update their interchange rates twice per year.

Most interchange fees are assessed in two parts: a percentage to the issuing bank and a fixed transaction fee to the credit card network. For instance, the per-swipe fee might be 1.15% plus $0.25. Interchange fees vary and are categorized through a process called “interchange qualification,” which determines the rate based on several criteria:

• Physical presence or absence of the card during the transaction
• Processing method used (e.g., swiped, manually entered or e-commerce)
• Credit card company
• Card type (e.g., regular, premium, commercial, rewards or government-issued)
• Merchant’s business type (as determined by merchant category code)

2. Assessments

Credit card networks (except American Express) charge this fee for transactions that are made with their branded cards. It usually is based on a percentage of the total transaction volume for the month. The fee usually is fixed, and the merchant’s acquiring bank may not charge a lower rate or negotiate a better deal with the merchant.

Assessments generally are charged per transaction but can vary depending on the pricing model the merchant follows. For instance, Visa might charge a 0.11% assessment plus $0.0195 processing or usage fee for each card swipe. Assessment amounts may change periodically. Combined with the interchange fee, assessments constitute between 75% and 80% of total card-processing costs.

3. Markups

Acquiring banks and acquiring processors usually will include a markup over interchange fees and assessments partly as profit and partly to cover the cost of facilitating credit card transactions. It constitutes between 20% and 25% of total card-processing costs. Merchants generally can negotiate the markup with the entities that charge them. Markups vary by processor and pricing model. They may also include other types of fees.

Chargebacks

Customers reserve the right to dispute a charge on their credit card billing statement within 60 days of the statement date. When the issuing bank receives a complaint from a customer, it charges the merchant between $10 and $50 as a penalty and for issuing a “retrieval request.” If the merchant doesn’t respond to the retrieval request within a certain timeframe, it could incur additional fees.

The merchant may appeal, but the process is long and likely to favor the customer. If the merchant loses, the issuing bank will recover, or charge back, the customer’s payment.

Common Reasons Why Credit Card Transactions Get Declined

Getting your credit card transaction declined is never enjoyable. It’s embarrassing. But the rejection of a credit card can be caused by other reasons besides maxing out the card.

When a credit card is declined, the point of sale (POS) terminal will return a response code that explains why. Sometimes those codes don’t tell the full story. In those instances, only your credit card issuer can identify the particular reason for the rejection, so you may need to call customer service to resolve the problem.

Some of the most common reasons your card might get declined are:

• Incorrect credit card number, expiration date or security code
• Expired card
• Insufficient funds
• Damaged card
• Card hasn’t been activated yet
• Broken payment terminal
• Technical issues with any of the parties involved in your transaction
• Transaction was flagged by your bank as potential fraud

Although there’s a variety of things that can cause your card to get declined, there are also a lot of measures you can take to prevent that from happening and ensure that your transactions go smoothly.

Tips for Smooth Transaction Processing

• Keep track of how much you spend on your card so you don’t max it out and get declined because your available credit isn’t enough for the purchase.
• Store your card in a safe place like a wallet so it doesn’t get damaged, which can lead to it getting declined.
• Call your bank if you’re traveling far from home so that they anticipate purchases in a different location and don’t accidentally flag them as potential fraud.
• Activate new cards as soon as you receive them. You can’t use your card until it’s activated.
• Double check all of your card info before submitting a payment when making a transaction online.
• Always insert your card into the card reader or tap it if possible, rather than swiping the magnetic stripe on the back. Just swiping is a lot less secure since it doesn’t use your card’s EMV chip.

Bottom Line

Credit card transaction processing is quick and easy, and you’ll know in seconds whether your card was approved or declined. Processing is also very safe because the EMV chip built into your card makes it very hard for fraudsters to get hold of your card info (especially if you’re able to use contactless payments). Plus, all major credit card networks offer $0 liability for fraudulent purchases.

You can learn more about how to use a credit card here on WalletHub.