How Credit Card Processing Works

The use of credit cards has become an inextricable part of our daily lives. Whether it’s online shopping, buying groceries at the local supermarket, or paying for a meal at a restaurant, credit cards offer a convenient way to make payments.

When customers want to pay with plastic instead of cash, you need more than just a card reader to accept their credit card payment. Processing that transaction involves a behind-the-scenes sequence of steps to ensure the funds get deposited into your bank account.

In this blog post we’ll lift the curtain and unpack exactly how credit card processing works.

The Key Players Involved

Understanding credit card processing also means understanding the key players involved in a transaction. Let’s break them down:

1. Cardholder: This is the individual or business that uses the credit card for payment
2. Merchant: The merchant is the business that accepts credit card payments for the goods or services they provide
3. Issuing Bank: This is the financial institution that issues the credit card to the cardholder
4. Acquiring Bank: This is the merchant’s bank, responsible for collecting payment from the issuing bank and depositing it into the merchant’s account
5. Payment Processor: The payment processor is the link between the merchant and the acquiring bank. They facilitate the transmission of transaction data
6. Card Network: The card network (Visa, Mastercard, Discover, American Express) serves as the conduit for transferring information between the issuing bank and the acquiring bank

Aside from the key players, there are dozens of other important terms and phrases related to merchant services. Check out our full glossary to learn more.

An Overview of Credit Card Processing

Credit card processing involves a series of complex transactions that take place within seconds. It’s a seamless coordination between multiple parties, including the cardholder, the merchant, the payment processor, the issuing bank, and the acquiring bank.

Here’s a simplified step-by-step process:

1. Authorization: The cardholder presents their card to the merchant for payment. The merchant’s terminal or point-of-sale (POS) system sends the transaction details to the payment processor.
2. Authentication: The payment processor forwards the transaction information to the card network (e.g., Visa, Mastercard), which then sends it to the issuing bank for approval.
3. Approval/Denial: The issuing bank checks the card’s validity and the cardholder’s credit limit. If everything’s in order, it approves the transaction.
4. Final sale: The approval message is sent back through the same chain – card network, payment processor, and finally, the merchant’s terminal, where the transaction is completed.
5. Transaction batching: Throughout the day, the merchant stores authorized transactions in a “batch”. This includes everything needed to actually process a payment. At the end of the day, the batch is finalized and sent to the credit card processor.
6. Clearing and settling: The issuing bank will confirm transaction details and verify them if everything matches up. From there, the issuing bank pulls the amount from the cardholder and passes it through the card network.
7. Funds transferred: After processing fees, the acquiring bank deposits the net amount into the merchant’s bank account.

The first four steps happen in a matter of seconds, making credit card payments one of the fastest and most convenient modes of payment.

The last three steps happen throughout the following few days.

Extra Steps for Debit Cards

If a customer uses a debit card vs a credit card, they may need to do some additional steps to validate that they’re the owner of the card. This could be a signature or entering their PIN number.

However, all the steps that happen after remain the same.

A Deep Dive into the Transaction Process

Now that you know how it works from a high-level, let’s break down the transaction process in more detail.

Authorization

This is the initial stage of any credit card transaction. When the cardholder presents their card for payment, the merchant sends the transaction details, including the card number, expiry date, CVV, and transaction amount, through their POS system or online gateway to the payment processor.

The payment processor then forwards this information to the card network, which sends it to the issuing bank. The issuing bank checks whether the card is valid and if the cardholder has sufficient credit to cover the transaction.

Authentication

Authentication is the process of ensuring the cardholder is the legitimate owner of the card. This can involve methods like entering a PIN, signing a sales draft, or an online verification system like Verified by Visa or Mastercard SecureCode.

Approval or Denial

The issuing bank checks the card status and the cardholder’s credit limit.

If the card is valid and the customer has enough credit, the bank sends an approval code back to the merchant through the same route.

If the card is invalid or the customer has insufficient credit, the bank sends a denial message.

Final Sale

Once the merchant receives the approval code, the transaction is complete and a receipt is printed. However, this is just the beginning of moving funds from the customer to your account.

Transaction Batching

Throughout the day as customers make purchases, the merchant’s point-of-sale (POS) system stores the transaction details in a “batch”. This includes key data like the card number, amount authorized, date/time, and auth code.

The POS system keeps each transaction in its open batch file until the merchant “closes” the batch, usually at the end of the business day. This process of settling all the day’s transactions is also known as batch processing.

Closing out the batch generates a batch report summarizing all the transactions, totals, and fees. This gets transmitted electronically from the merchant’s system to the payment processor.

In some cases, the POS system may automatically close batches at preconfigured intervals, like every few hours. Transactions may also be transmitted in real-time rather than batched.

But batch processing is still very common, especially for small to midsize merchants. It allows the terminal to function offline if connectivity goes down. And it provides a way to group all of each day’s transactions neatly together.

Clearing and Settling

Once the processor receives the batched transaction records, they are forwarded through the relevant credit card networks to the issuing banks.

The issuing bank checks over the transaction details to verify that they line up with the approved authorization it has on record. This checking process is called clearing.

Any discrepancies have to be resolved before the transaction progresses to the settlement phase. Common issues might include:

• Amounts differ between authorization and clearing. For example, tips added later at a restaurant
• Transaction ID numbers don’t match
• Errors in card numbers or expiration dates

As long as the details match on both sides, the issuing bank will move the transaction to settlement. This is the process of actually transferring the funds.

The issuing bank will:

• Debit or charge the cardholder’s account for the amount of their purchase
• Route the funds through the card network back to the acquiring bank
• Deduct an interchange fee that gets paid back to the issuing bank

This settlement process usually happens overnight in one big batch file. Then the funds are available in the merchant’s account the next business day.

Funds Transferred

Once the acquiring bank receives the collective settlement files from all the issuing banks, accounting reconciliations happen behind the scenes.

The acquiring bank sums up the net amounts after interchange fees and deposits the funds into the merchant’s bank account. This is referred to as funding the merchant.

Rather than receiving many small transfers from individual cardholders, the merchant gets one larger lump sum funding deposit. This makes reconciliation much easier.

The deposit appears as incoming ACH credits in the merchant’s bank account, with the transaction descriptions identifying the transfers coming from the acquiring bank.

Once the money is in the merchant’s account, the card processing cycle is officially complete!

Common Processing Issues

Unfortunately, the whole process doesn’t always go smoothly. Here are some of the most common issues merchants see when processing payments.

Declined transactions – This occurs if the issuing bank does not approve the sale, for reasons like insufficient funds or fraud concerns.

Voided transactions – If there are issues like a processing error, the merchant can void the transaction before it clears.

Disputed transactions – If a customer disputes a charge, it can be reversed later on through a chargeback process.

Held funds – Banks sometimes place longer holds on large transaction amounts before transferring funds.

Standard Fees Involved in Credit Card Processing

Processing credit card payments isn’t free. The most common processing fees include:

• Interchange Fee: This is a fee that the acquiring bank pays to the issuing bank. It’s usually a percentage of the transaction value plus a fixed amount.
• Assessment Fee: This is a fee charged by the card network (Visa, Mastercard, etc.) for using their infrastructure.
• Processor’s Markup: The payment processor also charges a fee for their services. This can be a flat fee, a percentage of the transaction, or a combination of both.

These fees are often bundled together and charged to the merchant as a single per-transaction fee. However, there are numerous other fees merchants may be responsible for as well.

The Role of Merchant Services Providers

The role of a merchant services provider in the credit card processing flow is to act as an intermediary between merchants and the other institutions involved. Here are some of the key functions a merchant services provider performs:

Sets up merchant accounts – Helps businesses through the application process to establish a merchant account with an acquiring bank to accept card payments.

Provides payment processing hardware/software – Merchant services providers supply or rent out point-of-sale terminals, payment gateways, and other transaction processing tools to merchants.

Manages transactions – Routes payment authorization requests from merchants to the relevant card networks. Facilitates the flow of transaction data between merchants and banks.

Deposits funds – After the acquiring bank transfers settlement funds, the provider credits the net amounts to the merchant’s account.

Customer support – Merchant services providers have dedicated support teams to assist merchants with any payment processing issues.

PCI compliance – Helps merchants properly implement data security standards to stay PCI compliant.

Reporting – Provides transaction reports, statements, analytics, and other tools to give merchants visibility into payment activity.

Rate negotiations – Leverages partnerships with banks and card networks to get reduced interchange rates and fees for their merchants.

Value-added services – Many providers offer additional services like fraud protection, disputed transaction management, accounting integrations, and more.

Essentially, merchant services providers handle all the complexities of payment processing so merchants can focus on running their businesses without needing to directly interact with the issuing banks, card networks, etc. They serve as an intermediary “middleman” facilitating the entire transaction workflow.

The Importance of Security

Credit card transactions involve sensitive data, making security critical. The Payment Card Industry Data Security Standard (PCI DSS) sets the security standards for businesses that store, process, or transmit cardholder data.

Merchants must ensure they use PCI compliant payment processors and adhere to the security standards to protect cardholder data and prevent fraud.

Conclusion

We hope this overview has helped explain exactly what happens during credit card processing and gave you insight into the different players involved.

Knowing the complex sequence of steps that every transaction must pass through gives you an appreciation for the technology and coordination required to make it happen seamlessly in an instant.

Next time you run a customer’s credit card, you’ll have more clarity about the hidden gears churning in the background to make sure your business gets paid quickly and securely.