1/ A cashless society run on cards

In the past decade, US transactions made in physical cash have fallen from over 40% to 19%. Quick and on-demand interactions are the new standard in today’s growing cashless society, and it all began with a simple cardboard store card. 

Diners Club was the first version of a store credit card that was mainly issued by restaurants to accept monthly billing from select loyal clients. Within the first year, they had reached 10,000 card members who wanted the convenience to buy now, but pay later.

Over the years, store cards have evolved far beyond restaurants. Today, nearly 58% of US merchants accept debit or credit cards as payment. For many businesses, deciding to support card payments is almost a given, but depending on your business activity and industry risk, there are important considerations that could impact your decision. 

What is the credit card network?

For cardholders, making a payment is incredibly simple and straightforward. At point of sale, the customer can either provide their credit or debit card information, or simply tap or swipe their card at the terminal. Within seconds, they’ll receive a response of an approved or declined transaction. Behind the scenes, however, is a whole network of entities working together to authorize a single transaction. 

For all parties to communicate and send messages to one another, a communication system is used, known as the card network. 

There are four major card networks that dominate the market: Visa, Mastercard, AMEX and Discover. Card networks are primarily responsible for regulating the use of cards and working with the necessary parties to facilitate payment. Some card networks, such as AMEX, are also issuers that directly provide customers with payment cards. Others, like Visa and Mastercard, will partner with banks and financial institutions to issue cards on their behalf. 

While they all operate similarly, each network has its own business model and fee structure to consider. For instance, AMEX is known to charge higher merchant fees to support its costs of issuing cards and funding its premium reward programs. As a merchant, you get to decide which card network your business supports, which will determine the type of payment cards you’ll accept from customers. Visa and Mastercard are the industry standards that account for over half of the total payment cards in circulation. Generally speaking, you can expect any business that accepts card payments to likely support Visa or Mastercard. Meanwhile, not every merchant will accept AMEX and Discover because of the higher fees. 

What parties are required to make a transaction?

There are several participants involved to make a single card transaction possible: 

  • Cardholder (your customer): Roughly 70% of the total US population holds at least one credit card and will choose to make a purchase with it over other methods.
  • Merchant (your business): As a merchant that accepts payments, you can choose the payment methods to accept that’s right for your business. 
  • Issuing bank (your customer’s bank): This is the financial institution that issues the credit or debit card to your customer and where the funds from the transaction sale will be pulled from.
  • Acquiring bank (your business’ bank): To accept card payments, you will need to have a merchant account and required payment processing equipment and software. Your acquiring bank will provide you with what you need, and give you access to the card network.
  • Card network (the communication system): As the bridge between the issuing and acquiring bank, the card network ensures that the transaction details are delivered to all parties and that the funds are securely transferred. 

How are credit cards processed?

The credit card process can be split into authorization and settlement. As a merchant, what’s most important to you at point-of-sale is the authorization process. This determines whether or not your customer’s payment will be approved or declined at the moment of the transaction. It’s important that you keep track of your authorization rate and balance just the right risk settings without turning away good customers. Once the transaction is approved, the settlement process where funds are deposited to your merchant account proceeds. As the merchant, you won’t have to worry too much about the settlement phase. The great thing about card payments is that the approved funds for your day’s sales are guaranteed to hit your merchant account, typically within 24 hours. 

Here’s an overview of how card transactions are approved:

  1. The cardholder provides their details. The customer enters their card information through an online payment gateway, or presents it to a physical payment terminal. 
  2. The merchant issues a request. The card and transaction details are captured and sent to the acquiring bank.
  3. The request is routed to the issuing bank. The acquiring bank takes the request and routes it to the issuing bank for approval using the appropriate card network. For instance, Visa cards are routed through Visanet and Mastercard cards are routed through Banknet.
  4. The issuing bank approves or declines the transaction. There are several pieces of information that an issuing bank will check for, like validating the credit card details, ensuring sufficient funds and confirming that the account is in good standing. 
  5. A response is sent back to the merchant. The issuing bank sends a response code to the acquiring bank and the merchant to let them know if the transaction was approved or denied. If the transaction is approved, it’ll move forward to the settlement phase where the approved funds are deposited into your merchant account. 

Believe it or not, the whole authorization process happens at an average speed of under two seconds, making it the quickest payment option available that guarantees funds. The customer can instantly walk away with their purchase, and within 24-48 hours, you, the merchant, should expect the transaction to be settled and funds deposited in your merchant account.

If the card transaction is declined, you’ll receive a message at point-of-sale that contains an alphanumeric code, known as a response code. Every network has its own set of response codes that help indicate the reason why a transaction failed, such as an incorrect PIN, invalid card number or insufficient funds. By knowing the reason for the error, you can work with your customer to fix the payment issue.

What you really want to avoid is processing an unauthorized payment that results in a chargeback. This typically happens when a customer sees their bill statement and notices an unfamiliar transaction. They will dispute the transaction and a chargeback will be issued to reverse the payment. As a merchant, you want to avoid this at all costs. Not only do chargebacks tarnish your merchant reputation, but you can also expect to pay a penalty fee that can range anywhere from $10 to $25 per chargeback. Especially for merchants operating in a high-risk industry, this can be a significant risk and cost to consider.

What card processing fees should you expect?

Though debit and credit cards have the advantages of speed and convenience, it doesn’t come without a major tradeoff. Processing fees, also known as merchant discount rates, is the service fee you pay to process each debit or credit card sale. On average, most merchants can expect to pay a 1.5-3.5% fee on every transaction, which is significantly more than most payment options. To offset or lower the costs, some businesses will up-charge customers, or only accept card payments of a minimum value.  

There are several factors that will impact the rate you pay, including:

  • Risk of transaction: how the payment is made matters. The more secure the transaction, the fewer fees you’ll pay. For instance, cards with PIN codes and in-person transactions are typically considered lower risk compared to transactions made online or over the phone.
  • Type of business: banks view certain industries and business activities as risky and will charge more fees as a result. Essential purchases like groceries and gas are low-risk, while transactions related to gambling or crypto are high-risk. To identify the business activity provided, banks use the merchant category code (MCC)
  • Type of transaction: additional details like the transaction volume, type of card used and foreign purchases can also impact the rate paid.

The total processing fee is typically expressed as a percentage (eg. 1.5-3.5% per transaction), but it covers the following fees charged by all the participating network entities:

Beyond these per transaction fees are additional one-time, merchant account or penalty costs, including PCI-compliance fees, annual account fees, chargeback fees and more. Though card payment fees are higher compared to other options, it’s a tradeoff many merchants and consumers are willing to take because of how seamless and convenient the interaction is. However, it’s important to note that if you are a high-risk merchant, you will have to consider all these fees, and more.

2/ Card payments for high-risk merchants

By now, you have probably noticed that risk plays an important role in the card payment process. The nature of your business and the risk of the transaction can significantly impact your processing rate and the additional fees you could be exposed to. That’s because the payment processor needs to offset the risk of servicing a merchant that has a higher chance of fraud, returns or chargebacks. As a business, it’s important to know if your provider considers you a high-risk merchant and how it affects your business.

What is considered a high-risk merchant?

There are several reasons why a payment processor may label a business as high-risk. Each provider has its own set of criteria, but you can expect these categories of reasons: 

  • New merchant: If you’re a new business starting out, you may be labeled as a high-risk merchant at the start, simply because you don’t have a robust transaction history yet. 
  • International business: If you serve customers in specific countries that are listed as high-risk of fraud, this may also label you as a risky business.
  • High transaction volume: If your business has a high monthly transaction volume, or high average transaction amount, this could expose you to more risk.
  • Poor record: If you have a history of high chargebacks or have a low credit score, your tainted record can tarnish your reputation in the eyes of the payment processor. 
  • High-risk industry: There is a list of industries and business activities that providers consider high-risk. Some examples include cryptocurrency, gambling, adult services, subscription services, travel and more.

How do banks identify high-risk merchants?

Assigned by card networks, the merchant category code (MCC) is a four-digit number that helps banks identify the type of industry or business activity a merchant is involved in. For instance, the MCC for crypto-related merchants is 6051[Quasi Cash]. When banks see this, they will classify it as high-risk and apply additional fees.

Some other ways that issuing banks use MCCs: 

  • To offer cashback or reward points for qualified purchases
  • To determine the interchange fee to charge merchants 
  • To identify and restrict transactions from prohibited industries
  • For tax reporting purposes 

There are over 500 different MCC codes and they can differ between card networks, but they are generally similar. Citi provides a good source for a comprehensive list of typical MCC codes.

What additional fees and terms should high-risk merchants expect?

Card processing companies will typically charge high-risk merchants 3.5% more than a standard merchant. In addition to that, you can also expect the following fees and contract terms: 

  • Long contract terms: For taking on the risk of working with a high-risk merchant, card processors may require longer contract terms of up to three years. 
  • Higher chargeback fees: Some providers may charge high-risk merchants higher chargeback fees to offset the risks. 
  • Early termination fee: If you cancel your merchant account before your contract term is finished, you will likely have to pay a high termination fee.
  • Liquidated damages: On top of your early termination fee, you may also be required to pay an additional amount that is based on the average credit card transactions multiplied by the number of months remaining in the contract. 
  • Rolling reserve: a percentage, typically 5-10%, of your monthly gross merchant sales could be held in a reserve for a period of time before it becomes available to you as a way for the provider to manage risk. 
  • Account freeze: In the worst-case scenario, the provider could choose to freeze or terminate your account if your business becomes too risky for them.

With these additional high-risk merchant fees and terms, you have to also consider how much you’ll upcharge your customers for it to make business sense. The more you charge, the less competitive your business will be.

3/ Bottom line

Credit and debit cards aren’t going anywhere. In fact, they are likely going to continue to grow in popularity, especially with the innovation of digital wallets. You’ll no longer need to carry a physical card around to make purchases when everything you need is on your mobile phone. For that reason, merchants and consumers will continue to pay higher card processing fees because of how convenient it is. However, if you are a high-risk merchant, like a crypto company, it’s important to consider the additional fees that will impact your business. If you are looking for a more affordable payment option, ACH bank transfer is another popular payment network to consider.