How credit cards work behind-the-scenes
Credit cards can seem like magic. The typical credit card transaction takes just a few seconds; you swipe your card and before you can even return it to your wallet, the transaction is approved and you're ready to go.
Credit cards have come a long way since the first modern style credit card was issued back in 1958 by Bank of America. In 1958, the BankAmericard was the only type of credit card around. Now, a little over fifty years later, there exists a huge variety of different card types: regular credit cards, debit cards, prepaid cards, rewards cards, business cards, affinity cards, and others. Additionally, companies like Square and PayPal have brought credit card processing to the masses. Now, anyone with a smartphone can accept credit cards.
However, one thing that hasn’t changed much is what happens behind the scenes when a credit card is accepted for payment.
In this article, we'll discuss the key players, data flow, swipe fees, and other details related to everything that happens behind the scenes when you pay with your credit card.
A credit card transaction is a carefully-orchestrated process involving several different entities.
- You (a.k.a. the consumer): The person looking to use a credit card for a purchase.
- The issuer (a.k.a. issuing bank): The bank who gave you that nice shiny credit card (e.g., Chase, Capital One).
- The payment network (a.k.a. association or interchange): The network that links everybody together (e.g., Visa, Mastercard).
- (Note: Technically, the term “interchange” only refers to the fee charged for usage of the network, but in common usage the term is often used to describe the network itself.)
- The acquirer (a.k.a. acquiring bank): The merchant's financial institution, which handles the processing of the transaction.
- The merchant (a.k.a. retailer): The store or person who is eager to take your money (e.g., Costco).
In order for a merchant to accept credit cards, they first need to have a merchant account with an acquirer. Acquirers can be a bank that has a merchant processing relationship with one of the payment networks, or they can be an independent sales organization. The role of the acquirer is to capture your credit card information at the point of sale and transmit it through the network to the issuing bank.
When the issuing bank responds to say that the transaction is approved, or declined, that information is sent back across the payment network to the acquirer, who then relays that information to you and the merchant.
The payment network is the backbone that links everything together. When you talk about Visa or Mastercard or Discover, you are talking about the network that links together everyone using, accepting, and issuing that particular type of card.
Visa’s network, for example, consists of over sixteen thousand different financial institutions, 29 million different merchants, and 1.5 billion cards all spread out across 170+ countries. This huge network of banks, merchants, and cardholders is what makes issuing credit cards profitable for banks and what makes accepting credit cards attractive to merchants.
More notes about payment networks
Almost all credit cards use one of four networks (i.e., transaction systems): Visa, MasterCard, American Express, and Discover.
Visa and Mastercard
Visa and Mastercard are not credit card issuers. Instead, financial institutions issue credit cards bearing the Mastercard or Visa name, and they pay fees to these entities to do so.
The vendors and service providers who accept your card have to pay fees to participate in these (Visa and Mastercard) payment networks. Financial institutions who issue you one of these cards (e.g., Chase, Capital One, Bank of America, etc.) generally set their own terms and conditions for card usage, fees, rewards, interest rates, and the like. However, when doing so, they must adhere to the rules and standards set by these entities (Visa and Mastercard), which govern the usage of those networks.
American Express and Discover
American Express and Discover are credit card issuers, while also being their own networks. They set their terms and conditions and govern the usage of their credit cards. These cards are typically accepted by fewer merchants, though they're both gaining steadily in popularity.
Another big difference for Amex is its issuance of charge cards that do not allow the user to carry a balance. This led to its reputation as a “higher-end” charge card. However, Amex now offers credit cards with balance-carrying options as well.
When you swipe your card
Now that you understand who all the players are in a typical credit card transaction, it’s time to examine exactly what happens when you swipe that credit card:
- When you swipe your card at the register, the reader captures all of the transaction information: card number, expiration date, amount of the purchase, and other optional security information like your zip code, and transmits that information to the acquirer.
- The acquirer sends that information across the network to the issuing bank. When the acquirer does this, they are authorizing the transaction. (An authorization is simply the merchant asking the issuing bank if the card is valid and if the funds are available. No money exchanges hands at this point.)
- If the card is valid and the funds are available, the issuing bank approves the transaction. The issuing bank will then put the necessary funds on hold and send a message to the acquirer informing them that the transaction is authorized. The acquirer passes that message on to the merchant, who then gives you your purchases and wishes you a good day.
This is the end of your involvement in the transaction, but it’s not the end of the transaction itself. At this point, the purchase is simply authorized; if you were to check your bank right now, you would most likely see the transaction displayed as a “pending” or “authorized” charge. The money has not yet been sent to the merchant.
When looking at your credit card account online, it's important to understand that a pending or authorized transaction is not final; the amount of the transaction can change. This is a common occurrence when you perform a transaction at a place such as an automated gas pump or a restaurant where the exact final amount of your transaction cannot be known in advance when the authorization is performed.
At the end of the day
Once the day is over, your credit card transaction continues:
- The merchant will take all the card transactions processed that day and lump them together in a batch. This batch is then sent to the acquirer, who passes it on to the appropriate network (Visa, MasterCard, etc.) This starts the process of “settlement.”
- The network will request funds from the issuing bank. The issuing bank will send the funds to the acquirer (minus the interchange fee).
- The acquirer receives the funds (minus the interchange fee) and from that amount deducts their merchant services fee. The final amount (minus these two fees) is deposited into the merchant’s bank account.
- The issuing bank posts the transaction to your account, and the transaction is now complete.
Fees are a very important component of credit card processing.
In any card transaction, there are two middlemen standing in-between you and the merchant: the acquirer and the issuing bank. Both of these institutions want to make a profit, and cover the costs, off of their role in processing your transaction. The issuing bank receives the interchange fee, while the acquirer receives the merchant services fee. When you spend one hundred dollars at a store, the merchant does not receive that entire amount.
The interchange fees vary significantly depending on the type of card and type of merchant. The interchange fee alone can get as high as almost 3% for certain types of cards on Visa’s network.
The merchant services fee can add another half of a percent or more to the total. Collectively, the fees paid by the merchant for interchange and merchant services are referred to as “swipe fees.”
If, for example, the total swipe fee to a merchant for your particular $100 transaction is 3%, the merchant will only receive $97 from your $100 purchase.
Swipe fees are why some merchants, especially smaller ones, will impose a minimum dollar amount on using credit cards, or will offer discounts for using cash.
As you can see, while credit card transactions may seem quick and easy there’s a lot going on behind the scenes.