From Swipe to Settlement: How Credit Card Processing Works

By Whitney Troxel

Credit card processing is a crucial component of any business’s operations. It is the backbone of modern commerce and is what enables businesses to function. It’s somewhat ironic that such a critical aspect of daily business is considered an enigma by the business community at large.

The operations involved in credit card processing are intricate and ever-evolving. A fusion of technology, financial institutions, and protocols work synchronously to complete a transaction. This complex web of interactions unfolds behind the scenes every time a customer swipes their card to make a payment — but few merchants understand the process or its impact on their business.

We’ve seen small business owners and CEOs of major corporations alike make destructive business decisions simply because they didn’t have a basic understanding of payment processing.

This article aims to analyze the credit card transaction process, exploring the essential players, technologies, and the importance for merchants to possess a deep understanding of these systems in order to ensure optimal business operations.

Let us show you how increasing your knowledge of payment processing can turn it from a necessary business component into a strategic asset.

Credit Card Processing Essentials

Let’s go back to the basics and start with a definition. Credit card processing is the process of accepting payments from consumers. This can be done through a variety of methods, including online, over the phone, or in-person. In order to process payments a business must have:

• A merchant account — an account with an acquiring bank that allows a business to accept credit card payments.
• A payment gateway — a software application that securely transmits credit card information between the customer and the payment processor.
• A payment processor — a third-party payment service that facilitates credit card transactions between a business and its customers (sometimes called a merchant services provider or credit card processor).

In the United States, financial institutions are the only entities that can possess electronic funds (i.e. credit cards, debit cards, Google Pay, Apple Pay, etc). Therefore, bank-to-bank transfers are the only way to move these digital money sources.

All other participants of this financial system — meaning payment gateways, payment processors, or merchant services providers — offer additional services or value.

Credit Card Transaction Lifecycle

A deep understanding of credit card processing is essential for businesses that wish to maximize their profits. It allows them to accurately track sales revenue, reduce payment delays and errors, as well as create cost-effective structures for receiving payments.

Being aware of the multiple possibilities offered through credit card processing empowers executives with the confidence required to make today’s decisions which will benefit their companies in the future.

The lifecycle of a transaction is laid out for you in the following order.

Step 1: Issuing the Credit Card

Before diving into accepting credit card payments, we need to understand how credit cards come into existence.

Credit cards are issued to consumers by banks or credit card networks, commonly referred to as issuers. Cards are typically issued after a detailed scrutiny of the consumer’s credit history.

Every credit card carries account information, including the cardholder’s name, the card number, and a magnetic strip or an EuroPay, Mastercard and Visa (EMV) chip. The latter two store data needed for every transaction and secure against potential fraud.

Once the consumer activates the card, they are able to use it for card-present and card-not-present transactions.

Step 2: Transaction Initiation

A transaction is initiated when a customer submits credit card information to your business, either in-person or online.

Your payment gateway collects the information and sends it to your payment processor for the next step. A payment gateway can collect information in the following ways:

• Online Payments — This is the most common form of payment processing and is used for e-commerce transactions or electronic payments. Customers input their credit card details manually.
• Point-of-Sale (POS) Payments — POS payment processing is used for in-person transactions and is typically done using credit card readers or terminals. Modern card readers can extract information from the card’s magnetic strip or EMV chip.
• Over-the-Phone Payments — Phone payment processing allows customers to make payments over the phone. The customer provides their credit card information over the phone and the business employee manually enters the information into their payment system.
• Recurring Payments — Recurring payment processing allows customers to set up automatic payments for a subscription service or other repeatable payment.

Specific information is required to accept payments, no matter collection method is used, including the following:

• Cardholder’s name
• Card number
• Card expiry date
• Card Verification Value (CVV)

Step 3: Authorization

Your payment processor takes the submitted information and verifies it with the card issuer to ensure that everything is in order. This includes address verification service (AVS), checking if the cardholder’s account has sufficient credit, and scrutinizing for any signs of credit card fraud.

Based on these factors, the issuer either approves or denies the transaction — known as the authorization response. This happens in real-time, typically taking just a few seconds.

Step 4: Clearing

Once a payment has been authorized, your payment processor sends the transaction information to the customer’s card issuer for processing. The card issuer deducts the funds from the customer’s account and sends them to your processor.

Step 5: Settlement

Your payment processor then settles the transaction by transferring the funds from the customer’s card issuer to your business’ merchant account. This process can take a few days to complete, depending on the payment method and the banks involved.

Your processor maintains a record of the transaction for both your business and your customer. You will receive proof of payment and your customer’s account will be updated once the transaction is complete.

Occasionally, customers will initiate a dispute or chargeback, but that’s a topic for another day.

Your payment processor then settles the transaction by transferring the funds from the customer’s card issuer to your business’ merchant account. This process can take a few days to complete, depending on the payment method and the banks involved.

Your processor maintains a record of the transaction for both your business and your customer. You will receive proof of payment and your customer’s account will be updated once the transaction is complete.

Credit Card Processing Costs and Fees

Let’s talk about the costs fees associated with credit card processing, as it can be a significant pain point for many businesses. The fees involved can be broken down into three categories:

1. Interchange Fees — These fees are charged to the merchant by the customer’s bank as a means of authorizing and completing a transaction smoothly. They serve as a compensation for the bank’s services involved in ensuring the security and accuracy of the transaction, as well as facilitating the necessary financial processes.
2. Assessment Fees — These are fees that the credit card networks (i.e. Visa, MasterCard, American Express, Discover) charge for each transaction, sometimes called a “per transaction fee”. The rates are typically a small percentage of each transaction and are determined by the overall volume of transactions processed by the merchant. These fees are used to maintain the credit card network’s infrastructure and cover operational costs. These fees may also vary based on the type of card used and the method of transaction.
3. Markup Fees — These fees, charged by payment processors and service providers, are compensation for the valuable services they offer. They encompass a range of costs associated with processing transactions, maintaining secure systems, and delivering reliable customer support and are typically charged as a monthly fee. It’s important to note that markup fees can vary significantly from one provider to another, as each may have its own unique pricing structure and fee schedule.

Many businesses mistakenly believe that rates and fees are the most expensive aspect of payment processing and assume cheaper rates will automatically equate to more revenue. This isn’t true.

Businesses lose substantially more money dealing with:

• Fraud — Every dollar lost in a fraudulent transaction actually costs your business $3.75.
• Chargebacks — Each chargeback typically costs $20-$50 in addition to the cost of the lost sale.
• Declined Payments — Visa reports that 24% of subscription credit card payments are declined.

Lower rates and fees don’t always save you money. Working with a payment processor that offers security measures and helps you fight fraud, avoid chargebacks, and streamline declined payments can be more beneficial in the long run — even if it seems more expensive upfront.

Finding the Right Payment Processor for You

At the end of the day, credit processing should be seen not as a mere cost of doing business, but as an opportunity for you to find a payment partner that can support your overall financial objectives.

Different payment processors can offer different benefits and drawbacks, so you need to evaluate what will work best for your business. When evaluating payment processors, you should consider the following:

• Business Type — It is essential to select a payment processor that has experience working with businesses similar to yours. The needs of traditional companies are different from those of SaaS companies, which differ from the requirements of service providers such as doctors, lawyers, realtors, etc.
• Business Industry — Since payment needs and challenges can differ significantly based on the industry, processors frequently specialize in different industries. If you partner with a processor that doesn’t understand your specific business needs, it could lead to lost revenue, held funds, and closed accounts.
• Processing Volume — How much income you generate is a key factor when choosing a processor. Processors that work with high processing volumes can offer advanced technology and services that may be too costly for businesses handling low processing amounts.
• Ambition for Growth — If you want your company to reach its full potential, you must select the right payment processor. It should offer solutions that will evolve with your business, not impede it! Too many entrepreneurs and executives restrict their growth by failing to plan ahead.

It’s always a good idea to research multiple options before choosing a processor. Take advantage of the sales process to make sure you find the right fit. Don’t be afraid to ask questions. You’re looking for a company that will become a partner, not just a provider. How they respond to your questions — especially the “dumb” ones — will give you good insight into what working with them will be like.

Turn knowledge to action

Now that you have a deeper understanding of payment processing, let’s talk about how this information will help you make smarter decisions.

1. Ask more detailed questions. Too many business owners and executives lock themselves into detrimental contracts because they don’t know what to ask. Reading this article is not going to make you a payments expert, but it should help the payments industry be less terrifying. Engage payment processors and experts in conversation and keep learning!
2. Develop a payment strategy. Don’t just plan for now, plan for the future. Always ask yourself “Will this payment solution still work for my business at our next stage of growth? The stage after that?” Identify growth blockers before they happen and plan how you’re going to resolve or avoid them.
3. Talk to Nexio. Nexio provides a variety of payment solutions for a wide range of business types. Whether you’re a small business, a Direct Sales organization, or a SaaS company, we curate unique solutions that match your needs. Contact us for an obligation-free consultation and discover how Nexio helps you make payments a strategic asset.