At the start of 2021, only 13% of individuals paid with cash, leaving the rest of the payments to be completed electronically using a debit card, credit card, or online payment service like Apple Pay. To put it simply, the world is quickly moving toward fully digital transactions that rely on electronic means to pay for everyday products and services.
Since credit and debit cards are used as the main payment methods, it’s important to understand how processing these cards works to gain more knowledge as to how it can convert into profit for your business.
Credit card processing is a multi-step process that transmits customers’ credit card or debit card data into a dollar transaction from their financial institution to the merchant’s account. Credit card processing works by transmitting customers’ credit card and debit card data from their financial institution to the merchant’s account. From the moment your customer swipes or enters a credit card to when the merchant completes the transaction, credit card processing provides the software and services to make these payments possible.
It’s critical to understand how credit card processing works, so you can find the right processor for your company. This next section will thoroughly explain how this process works to give your business the necessary knowledge it needs to make more informed decisions moving forward.
A look into how credit card processing actually works
Credit card processing can seem like a simple process where the customer swipes or enters his or her credit card details and the merchant simply accepts it, but there are a lot more parties involved.
Here’s a more in-depth look into what accepting credit cards looks like:
- The customer provides his or her credit card information to the merchant.
- The credit card information is sent to the merchant’s payment processor for authorization.
- The payment processor then sends the request to the issuing bank to verify the cardholder’s credit or bank account is trustworthy and acceptable.
- The bank either approves or denies the request.
- The approval/denial is sent back to the payment processor, who sends it on to the merchant.
- The merchant will then either complete or cancel the sale based on whether the card was approved or not.
Despite all these steps taking place within a few seconds, there are still a lot of technical operations and various parties involved behind the scenes.
What parties are involved in credit card processing?
Since credit card processing is a complex, multi-step process, it’s important to understand each party’s involvement.
Below are the eight parties involved in credit card processing and how they work together:
- Cardholder: This is the individual or company purchasing a product or service with a credit card.
- Merchant: The merchant is the company selling products or services to its customers. The merchant accepts credit cards from customers by collecting their credit card information. The merchant then sends a payment authorization request to its acquiring bank.
- Acquiring bank: This is the account of the merchant where credit card payments are deposited into. When the bank receives the payment authorization request, it sends and shares the request response with the merchant.
- Payment processor: Payment processors provide the software that processes credit card and debit card transactions for the merchant. The payment processor can also install hardware, such as POS terminals, for in-person sales. The payment processor can be the merchant bank but many times it’s a third party.
- Independent sales organizations (ISOs): A third-party ISO will come in if merchant banks don’t process credit card payments.
- Membership service providers (MSPs): Similar to ISOs, MSPs take over the payment process from the merchant bank by managing daily transactions.
- Cardholder bank: The issuing bank is the credit cardholder’s bank. They provide credit to the cardholder, so the cardholder can purchase products or services.
- Credit card networks: Credit card networks are the major credit card brands like MasterCard, Visa, Discover, and American Express.
The three main steps of credit card processing
Now that you have a general idea of what credit card processing is and the major parties involved, it’s important to understand the three main steps involved in this process.
Credit card processing can be broken down into three key steps: authorization, authentication, and settlement.
Authorization is the first phase of credit card processing which includes the following steps:
- The cardholder presents their credit card information to the merchant. This can be completed online or by manually entering the credit card into a POS terminal.
- The merchant requests payment authorization from the payment processing company.
- The payment processor sends this request to the credit card networks.
- The credit card networks send this request to the issuing bank.
- The issuing bank either approves or denies the request and sends that answer to the credit card networks.
- The credit card networks send an approval or denial to the payment processing company.
- The payment processor sends an approval or denial to the merchant.
- The merchant shares the approval or denial response with the cardholder.
- If approved, the merchant provides the products or services to the cardholder.
After the transaction has been successfully authorized and completed, the authentication phase can take place. Authentication occurs when the issuing bank verifies the transaction is valid. This includes the following steps:
- The credit card networks request authorization from the issuing bank.
- The issuing bank then confirms that the cardholder’s account is approved for the transaction with the merchant and validates the cardholder’s identification information (i.e. name, address, social security number).
- The issuing bank sends an approval or denial to the credit card networks and merchant bank.
- The issuing bank places a hold on the purchase amount for the cardholder’s account.
- The merchant’s POS terminal or software batches approved authorizations for processing.
- The merchant then sends a receipt to the customer for proof of sale.
The settlement phase is when the merchant receives the funds from the cardholder. Settlement includes the following steps:
- The merchant’s POS system sends the batched payment authorizations to the payment processor.
- The payment processor sends the batch to the credit card association.
- The credit card networks forward this information to the issuing bank.
- The issuing bank charges the cardholder’s bank account for authorized payments.
- The issuing bank removes the interchange fees for the credit card networks and transfers the rest of the funds to the merchant’s bank.
- The merchant’s bank distributes the funds to the merchant account.
- The issuing bank notes the transaction to the cardholder’s account statement.
Knowing these three key steps is crucial to understand the ins and outs of the credit card processing process. The next section will discuss how to start accepting credit cards for your business.