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How Credit Card and Other Payment Processing Work

Small business taking payment cards should know how payment processing works

More and more, customers prefer to pay with credit cards or debit cards. Whether you run an online store or a physical store, you’ll have to take payment cards just to survive. But what happens after a customer pays with a card or from their bank account? How does payment processing work, from a merchant’s standpoint? As a small business, you’ll have to understand at least a little bit of this.

Here’s why.

Why You Need to Know How Payment Processing Works

Do you really need to understand how payment processing works just so you can take credit or debit card payments or make other types of money transfers? Probably not.

But the payment processing industry is unique and has its own lingo. As a merchant, you’ll eventually have to deal with returns, refunds, and maybe even fraud. Then, you’ll be looking at a statement full of strange terms wondering why you’re being charged for all sorts of things you’ve never heard of.

This is why we think it helps if you have a basic understanding of how modern-day payment processing and money transfers work. Once you have a general idea, you can understand why and how you’re being charged. Then, you can argue about the charges if you have to.

In the next few months, we’ll be writing about how payment processing works and how you can find the best payment processor for your business. It’s a big subject, so we’ll have several intro blog posts. Each intro post will link to more detailed articles in specific areas.

This post you’re reading is our first intro post. It focuses on the mechanics of payment processing. In addition to describing the various process flows, we’ll also explain industry-specific terms like merchant account, reserve account, ACH, SWIFT, and chargeback.

The next intro blog post will focus on the different types of payment processors like Stripe, Square, Fiserv, and Chase Payments. We’ll talk about different business models and which of these models might be best for your business.

The last intro blog post will touch on the future of payment processing, fintechs, and cryptocurrency. We’ll explain what they are and how, as a small business, you might want to deal with them.

So, let’s start with an overview of how payment processing works.

How Credit Card Processing Works

A credit card, in essence, is a bank’s standing loan to a cardholder. That bank is called an issuing bank. It’s the bank the cardholder pays the credit card bill to every month.

When a customer uses a credit card, the card number and the amount charged are sent through a computer network. The exact network depends on which card is used. So, Visa has its own network, Mastercard has its own network, and so forth.

The network runs a few checks to see, for example, if the customer has exceeded their credit card limit, if the charge looks like a fraudulent charge, and similar.

If everything checks out, the issuing bank pays the charged amount to you, the merchant. Then, at the end of the billing cycle, the issuing bank sends a statement to the cardholder, who can choose to pay all or a part of the month’s charges.

This is an extremely simplified explanation of how credit card processing works. If your business takes credit cards, then it’ll help if you dig a little deeper into the process. For example, you should know what an acquiring bank is, what a merchant account is, and how a reserve account could be used.  

We explain all the terminology and the differences in two articles on how credit card processing works. (It’s a big subject, so we had to break it down.) We highly recommend you at least skim the articles:

East Peasy Guide to How Credit Card Processing Works

Trouble in Credit Card Processing Paradise: Refunds, Chargebacks, and the MATCH List

How Debit Card Processing Works

To understand how debit cards work, it’s easier if you first understand how credit cards work. This is because there are two different ways you can charge a debit card: the traditional debit card method and the newer “credit” debit card method.

With the traditional debit card method, you’ll need a card terminal with a PIN pad. After you swipe/insert/tap the card, you have to enter your PIN. Your debit card information and the charged amount go through a special debit card computer network. The charged amount is taken out of your bank account and deposited into the seller’s merchant’s account almost right away. Because you have to use a PIN pad, you can use this method only for in-person purchases.

With the newer “credit” debit card method, you’re sending your debit card information through a credit card company’s network. In the US, this means Visa, Mastercard, or Discover. The network does its usual fund availability, fraud, etc., checks just like it checks every credit card charge. The big differences are that:

  • The network checks how much you have in your bank account instead of how much of your credit card limit is left, and
  • The money is taken out of your bank account almost right away instead of holding all your charges until the end of your billing cycle.

All online debit card charges use this “credit” method because this method doesn’t need a PIN pad.

So why would a merchant use the PIN method over the “credit” method or vice versa? Cost. Usually, the traditional PIN pad method is cheaper for a merchant.

Again, there’s much more to how debit card processing works than what we present here. We encourage you to read our detailed article:

How Debit Card Processing Works, for Small Businesses

ACH Transfers—The Backbone of the Electronic Money Transfer World

Most people are familiar with paycheck direct deposits. And, more and more, people are paying their utilities or credit card charges directly from their bank accounts. Whether you know it or not, this form of payment is called an ACH transfer.

ACH transfers aren’t just for consumers. If you’re in the US, ACH is one of two types of money transfers banks use when they transfer money to each other. (The other is wire transfer.)

There are two flavors of ACH transfers: pull and push. With pull transfers, you authorize a business—maybe your electric company—to pull money from your bank account on a certain day of each month. The exact amount might differ, but, as long as you have money in your account, you’ll always pay your bill on time. Pull transfers tend to be recurring.

Push transfers, however, tend to be one-time transfers for an exact amount. You, as the payor, control how much and when you want to pay. Money is pushed from your account to the recipient’s account following your directions. You can still pay your utilities with a push transfer, but you have to remember to set it up every month.

In the US, ACH transfer is also one of the main ways banks send money to each other. This often happens in the background, as a part of another type of payment process. For example, when a customer uses a credit card to buy something from you, the issuing bank usually pays you using an ACH transfer.  

Right now, you can use ACH to transfer up to $1M per day. Each day, there are four windows to do ACH transfers.

To understand how ACH works in more detail, see our full article.

How ACH Transfers Work, for Small Businesses

How Wire Transfer Works

Before ACH came along, when banks transferred money to each other, they used wire transfers. Wire transfers can be done at any time. There is no upper limit on the amount you can transfer, unless the bank making the transfer limits the amount.

Although it’s all called wire transfer, the banks actually use several methods to transfer the money. If the banks already do business with each other, then they might send the money directly to each other. Otherwise, if the wire transfer is between banks in the US, they often use one of two wire transfer networks. One network is called Fedwire. The other is called CHIPS.

There are other networks around the world that also do wire transfers. The most popular and well-known one is called SWIFT.

Wire transfers typically cost more than ACH transfers. One reason is that it usually requires a live person in a bank to initiate the transfer. Another reason is that each bank gets to set its own fee for wire transfer, so some of them charge quite a bit.

For international wire transfers, sometimes you need to send the money through several banks before it gets to the destination bank. Since each bank charges a fee and you don’t always go through the same bank even if you always only send from Country A to Country B, international wire transfer costs can often be hard to predict.

Not every small business needs to do wire transfers, but for those who do, they do it often. If you are or expect to send lots of wire transfers, you can benefit from understanding the mechanics of wire transfer. We recommend you at least skim our detailed article on how wire transfer works:

How Wire Transfers Work, for Small Businesses

How Checks and eChecks Work

A long time ago, when you write a check, you eventually get your cancelled check back in the mail. Back then, there were large check processing centers around the country that moved physical checks along. Now, however, you don’t get your check back. If you need to see your cancelled check, you usually have to go online to your bank’s website to download it. While there are still physical check processing centers around, the volume of processed checks is steadily decreasing.

Modern day check processing still often involves moving pieces of paper, but only to a very limited extent. Checks are often converted to electronic format early in the deposit process (e.g. you can deposit checks by taking a photo of them using your smartphone). Then, the money is basically moved around using ACH transfers.

Despite their waning popularity, there are still uses for checks and eChecks. In fact, some payment processors use eChecks to help merchants in high-risk industries take payments.

If you’re a merchant in a high-risk industry (e.g. CBDs, online gambling, pharmaceuticals, firearms, and similar), you might want to read our detailed article on how checks and eChecks work. This way, you can understand how high-risk payment processors can help you take electronic payments.

How eCheck and Check Processing Work

The Rise of the Fintechs and the Future of Payment Processing

One of the hottest tech startup areas is fintechs. In 2021, fintechs accounted for $210 billion in startup investments globally.

If you’ve read our detailed articles on how credit and debit card processing work, you’ll see that the current process for these vital financial services is complicated, convoluted, and antiquated. Lots of companies have a hand in the process flow, and they each charge what they want. The companies downstream of the flow simply pass the costs all down to you, the merchant.

The financial industry is also highly regulated by law. This creates a barrier to entry for newer financial services businesses.

So, what you have right now is an industry that is happy with the way they do things, happy with how and how much they charge for their services, and, because of a lack of competition, has very little incentive to make changes or charge less.

If you’ve read our article on how to find a great business to get into, you’ll know that this is what an industry ripe for change looks like.

Enter the fintechs. Fintech stands for financial technology, and they work in all aspects of anything that has anything to do with financial services, from lending to money transfer to fraud detection. They’re usually well-funded, so they can hire high-priced lawyers to deal with financial regulations. Little by little, fintechs are chipping away at the established way of doing things.

But you won’t understand what these fintechs are trying to change unless you first understand how payment processing and money transfers work right now. So, we encourage you to read and understand all our articles linked to from this post.

Next Up, Selected Payment Processors and Their Typical Charges

Now that you understand how payment processing works, it’s time to go into our next series. Our next blog post will introduce you to some payment processors and give you quick summaries on how and how much they charge for payment processing.

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

Questions? Comments?