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How Credit Card Payments Work

How Credit Card Payments Work

You have your product or service out there, you have some clients, but how are you going to charge them? Obviously you will always try to do it in the way which is least costly for you. You will look for the method that implies the smallest percentage transaction taken from any of the parties involved in the payment process.

Today we’ll start covering credit card payments which is the way most start-ups actually start getting paid.

Let’s define which parties are implied in the whole process. I divided them into 2 groups: either they are roles in the process or interactions in the process itself.

The different roles or participants are:

  • the merchant (you as business owner)
  • the merchant’s bank (aka the acquiring bank, your bank)
  • the cardholder (your customers)
  • the cardholder’s bank (aka the issuing bank, your customer’s bank)
  • the credit card network
  • the payment gateway


Roles in credit card world
Roles in credit card world

Then there are the interactions between these roles, which we will cover after detailing who is who among these participants.

Who Is Who?

Merchat and Acquiring Bank
Merchant and Acquiring Bank

Any merchant that wants to accept payments with credit cards will have to sign an agreement with his bank or the entity that is going to process his payments. From now on, we can refer it as the acquiring bank: the bank that processes credit card payments on his behalf.

In that agreement the merchant will agree to comply with the payment regulations established by the PCI (Payment Card Industry), a security standard. The acquiring bank must be already a PCI-compliant entity.

Cardholder and Issuing Bank
Cardholder and Issuing Bank

On the other hand, we have the cardholder (your customer). In order to own that card, the cardholder asked for it from his bank, which we will name as issuing bank.Both cardholder and issuing bank must be also PCI-compliant.

PCI Compliant
PCI Compliant

The other participants that take part in this process are:

  • the Credit Card Network, also known in some cases as Card Associations.We can think of this participant as the missing link in the chain, connecting different credit card companies.
  • the Payment Gateway, the service that authorizes credit card payments and processes them securely through a user’s merchant account.

What Happens When a Client Pays You?

Following the money in this multi-stop journey will make it necessary to introduce two important actions:

  • Authorizations: Any approval done during the payment process. Whether it’s done between a bank and the cardholder or the merchant, or done between a bank and the credit card network, it’s an authorization. Marked in the image with black lines.
  • Settlements: Processing the sale, transferring the funds from the issuing bank to the merchant’s account and billing the cardholder. Marked in the image with green lines.

Both actions have processing fees intrinsically attached to them. That means that if your client paid you a certain amount, you will receive a slightly smaller amount because the participants in those interactions will take a fee at every step of the process.

Authorization actions are usually fixed-cost, and are done by a payment service provider (an entity different than a bank). Meanwhile, settlement actions often use percentage-based fees.

The payment process looks like this:

Credit Card Payment Process
Credit Card Payment Process
  1. Let’s say a customer (a cardholder) decides to pay with a credit card for one of your products or services. Let’s say the bill comes to $100 USD.
  2. You submit your cardholder’s information to your bank (the acquiring bank). A payment gateway will handle your bill, routing it to the credit card network. Just for this, you could lose between 0.10 – 0.12 % of the total in fees.
    After that, the credit card network will take another 0.08% of your bill for routing it to the appropriate credit card company.
    At this moment the credit card interchange takes place. Yes, it has a fee too, typically around 0.09%. Basically this is the fee that has to be paid between banks for the acceptance of card based transactions. This fee is usually paid by the merchant’s bank to the cardholder’s bank – and made good at the other end by you.
  3. Once this is done, the issuing bank will verify the available cardholder’s funds. The issuing bank will take a fee too, usually of about 1.93%. If the verification checks out, it starts its way back to charge the cardholder. The detour is done through your merchant’s account at the acquiring bank (that takes a 0.65% fee). At this point, you’ll see in your bank that your bill has been paid: $97.15.
  4. Let’s break that down really clearly:

*Note: Take the amounts listed here with a grain of salt. They might vary, depending on when you read this (these figures are from January 2015) as well as where you’re doing business. You can make your calculations more accurate by finding out how much specific credit card providers like Visa or MasterCard take in fees.

Say Hi to Payment Processors!

You might be a bit confusing after reading all this, wondering: ‘Do I have to worry about all of this when starting a new business?’. No, technology – once again – comes to the rescue…

Payment processors are the new participant in this flow. And you might know some of them already, like Stripe, Braintree, or Paymill. Their place in the credit card processing flow is between the merchant and the payment gateway. Usually payment processors are different from merchant’s bank entities, and they are the ones which will handle credit card transactions for merchant’s acquiring banks.

Payment Processors
Payment Processors

Payment processors allow you to move faster by offering you a platform that will do the whole process for you. A payment gateway lets you start charging instantaneously. But at what price?

While banks charge around 1% – 1.5% per transaction, the payment processors that we list here charge take an average of 2.80 – 3% of your final transaction. From $100, that’s not so bad, but from $10, 000 it’s a painfully large chunk of change.

Payment systems have to be PCI-compliant, so if you are a user, it’s likely you would have signed an agreement accepting the condition of being PCI-compliant too.

An interesting change: Why Supermetrics included Stripe besides PayPal

Supermetrics pricing has always offered methods of payment to pay for their software. I saw they changed over time, though, going from offering payment only via PayPal in 2013 to supporting Stripe in 2014. Why do that, if PayPal offers almost all the same options as Stripe? I contacted their CEO, Mikael, to learn more about this.

Mikael Thuneberg
Lots of potential clients were asking to pay by credit card. While _PayPal does have a direct credit card payment option, they try to encourage or force people to pay using a PayPal account so they get a fee in every payment they process_.Many clients reported that they didn’t see the option to pay directly by card. For instance, we learned that if PayPal detects a cookie indicating that a PayPal account had been previously used in that browser, they will hide the direct card payment option.We tried to instruct people to delete cookies or use a different browser. In the end we felt that all this was making it too difficult for people to just buy our tools. _We decided to implement Stripe_, along with PayPal, to have a more visible way of payment by credit card.Mikael Thuneberg / Supermetrics

Take a look at the Supermetrics checkout page without and without credit card method of payment fully integrated

Supermetrics

Want feedback about what is the best payment method for your business? Please reach out (contact info below). I’ll be glad to help you out!

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* At Quaderno we love providing helpful information and best practices about taxes, but we are not certified tax advisors. For further help, or if you are ever in doubt, please consult a professional tax advisor or accountant.