How Does Payment Processing Work?

If you own a business, or plan to start one, you will inevitably face the decision of choosing a credit card processor. These companies are a crucial piece of the entrepreneurial team that helps everyday work proceed smoothly. Plus, they do a lot more than just the processing of payments. If you choose wisely, it’s possible to find a credit card processing company that works quickly, charges reasonable fees, and is willing to work out any problems encountered with particular billing situations.

Just as you’d give serious thought to hiring an attorney or accountant, it pays to consider all the pertinent factors that go into payment processing before deciding on a company to work with. For a basic but comprehensive grasp of payment processing, it’s important to know who the players are, what the three major parts of the process are, and what the steps are that begin with a consumer presenting a CC for payment and end with money going into the merchant’s bank account. In all, there are 11 steps in the entire flow of actions that begin when someone pulls a credit card from their wallet and says, “I’ll pay with this.”

Who are the Players?

In many different types of financial transactions, including applying for a mortgage, obtaining a personal loan, buying a car, applying for corporate credit, or incorporating a small business, there are numerous participants, players who all have a stake in the transaction. When it comes to CC payment processing, the situation is no different. In fact, there are at least six entities, including the original purchaser/cardholder, who make up the entire group of folks who touch a given CC transaction. Who are they, and why are they important? Here’s a brief list with salient points about each of the six:

  • The consumer: An individual who uses a credit or debit card to pay for something, either in person, over the phone, or via an online point of sale. Consumers are using cards that have been issued by banks. Sometimes banks issue cards directly and at other times they use credit card associations. See the following sections for further explanation
  • The merchant: Any company that allows customers to use credit or debit cards to pay for services or goods
  • The merchant bank: The banking establishment where the business maintains an account. Merchant accounts typically allow for acceptance of many types of payment, including cash, checks, credit cards, and debit cards
  • The payment processors: These entities are central to the entire process because they link consumers, merchants, merchant banks, CC associations, and issuing banks. Processors make certain that every step of the cycle takes place without a hitch.
  • The banks that issue the credit cards, or “issuing banks”: Entities that issue credit and debit cards to their account holders, who are either individuals or companies.
  • Credit card associations: Commonly known as “credit card companies,” these are the organizations whose names appear prominently on many CCs, like Visa, American Express, and Discover. Their role is to set qualification guidelines for potential cardholders and to establish various fees for usage, interest rates, etc.

Of course, there are numerous fees associated with credit card processing, so it’s wise to understand how most of them work and what they are for.

What are the Processes?

The main processes within the CC payment system are easy to remember because most everyone has had experience with them. They being with authorization, move on to settlement, and end with funding. Even though there are three pieces to the process, there are four key facts to know about this segment of the CC cycle:

  • There are 6, 3, and 2 steps, respectively, associated with authorization, settlement, and funding of any CC transaction. The authorization phase is the most complex while settlement and funding typically proceed automatically after full authorization is complete.
  • Authorization involves verifying that the card is valid and the cardholder is in fact the owner of the account in question
  • Settlement pertains to the activity among banks, merchants, and merchant CC processors to make sure all the data for payment amount, payment date, and cardholder are correct
  • Funding, the final phase, is the part of the cycle in which money actually moves from the cardholder to the merchant, but with several distinct steps in between the beginning and end of that journey

Credit card processing companies are evolving, primarily to attract more clients among the millions of small-business owners around the world. Some are even beginning to offer special deals for new customers and cut-rate packages for long-term clients.

From Beginning to End: How Credit Card Payment Processing Works

What are the 11 steps of the CC cycle, from presentation of a card for payment to the merchant receiving funds in their account? In most transactions, the order goes like this:

  • Presentation of CC for payment
  • Merchant conveys a RFP, request-for-payment to the payment processor, PP
  • The PP sends data about the transaction to the card association
  • The issuing bank receives various authorization requests concerning card number, expiration date, holder’s full name, etc
  • Issuing bank chooses to approve or reject (decline) the request
  • Issuing bank sends all the pertinent data to the card association, the seller, and the seller’s bank
  • Sellers (merchants) transmit everything to payment processors
  • The PP sends the data to the card association, who then conveys to the issuing bank
  • Issuing bank effects a charge for the correct amount to the consumer’s account
  • Issuing bank sends the appropriate amount of money to the merchant bank
  • Merchant bank places the appropriate amount of money into the seller’s (merchant’s) bank account

What Every Business Owner Should Know

There’s no need to become an expert in the field of CC payment processing, but any entrepreneur needs to know the basics. That means understanding the simply categories of common charges, what the flow of the process is like, what typical fees are, how to evaluate a processing company, when to change CC payment processors, and how to deduct the fees on tax returns.

Of course, topics like taxation and process flow can get highly technical and should be left to the experts. But, just as you would never walk into a car dealership and let the salesperson choose your vehicle, it’s best to know the fundamentals about payment processing so you can make informed judgments in the best interest of your business.

What’s the least you should know? For starters, learn who the six parties are in credit card transactions. Hint: it’s not just the merchant and the customer. Second, learn the distinct processes that make up the system, namely “ASF,” which stands for authorization, settlement, and funding.

Finally, review the 11 steps, from start to finish, that are part of a standard credit card transaction. By simply reviewing the steps, processes, and parties in payment processing, you’ll gain a well-rounded understanding of how the entire system works. There’s no better way, short of becoming an accountant or attorney, for getting a handle on how payment processing operates.