Merchant Services 101: Complete Guide to Credit Card Processing

Merchant services allow SMBs to accept credit card payments online and in-person while also maintaining a level of security to mitigate fraud and lost capital. Once a cash-based economy, the world has increasingly adopted credit and debit cards. Now, cash accounts for just over a quarter of purchases. While some of the move away from cash can be attributed to the rise of ecommerce, consumers are following the trend for in-person transactions, which still account for nearly three-quarters of all transactions.

Though debit and credit cards make it easier and faster to complete transactions, they don’t come without risks—namely, fraud. In fact, fraud is the top payment-related challenge for retailers. Many merchant account providers have anti-fraud services, including end-to-end encryption, tokenization, and two-factor authentication. The best merchant services also help businesses stay on top of payment trends like contactless payments.

What Is Merchant Services?

Merchant services is an umbrella term that includes a number of tools provided by financial institutions. In addition to a merchant account, the best merchant services also typically include security features like encryption to protect both the merchant and the customer during transactions.

Merchant services may also include payment processing, ACH transfers, gift cards, customer loyalty programs, payment gateway, the ability to accept credit cards online, mobile payment processing, and merchant cash advances.

How Does Credit Card Processing Work?

To understand how credit card processing works, it’s first helpful to understand who’s involved:

• Merchant: The small business that is selling products and/or services to the end customer; they are the ones receiving money.
• Customer: The individual or business who is making the purchase; they are the ones providing money in exchange for products and/or services from the merchant.
• Merchant bank: The financial institution where the merchant keeps their funds.
• Payment gateway: Technology that allows merchants to securely accept credit card payments from customers.
• ISO/MSP: The Independent Sales Organization (also known as Member Service Provider) is a liaison between the card issuing bank and the merchant.
• Issuing bank: The financial institution that provides the customer with their credit or debit card.
• Card association: Visa, MasterCard, American Express, and Discover are card associations.

The full credit card processing procedure—from when a customer presents a payment card to when the funds are deposited into your business bank account—can be broken down into three key steps:

1. Authorization
2. Authentication
3. Settlement

Authorization

Credit card authorization is the transaction approval or denial process that happens at the point of sale. Your customer presents their card and the payment amount is transmitted to your payment processor, who then forwards the amount to the customer’s card association.

The card association will send the request to the customer’s bank—also known as the issuing bank, who will then approve or deny the sale. This approval or denial notification then gets passed back down from the card association, to the payment processor, and finally to the merchant, where the approval or denial will be indicated at the point of sale.

If the transaction is approved, the merchant will receive an authorization number.

Authentication

Payment authorization is the process of verifying the customer account after the point of sale. After the customer’s bank validates the transaction, the card association and merchant bank are notified and a hold is placed on the customer account. Payment authorization and authentication happen automatically and behind the scenes, so business owners do not need to take any action with these first two steps.

At this point, the merchant’s POS or payment terminal can start the process of batching and sending out approved transactions for payment.

Settlement

The settlement process is when the merchant actually gets paid. Many merchant services will batch and process transactions automatically, but depending on your processor, you may need to manually batch and settle transactions at each terminal at the end of the day. Either way, you’ll want to monitor all of your statements to make sure there are no outstanding authorized payments.

Credit Card Processing Fees Explained

Credit card processing fees can be rather complicated because there are so many entities involved, and because the fees are not standardized between different merchant service providers. So, the types of fees you pay with one company might be completely different from the structure another merchant service provider uses.

Essentially, processing fees include the following:

• Account/service fee: Similar to a statement fee, this is a hidden cost companies add to cover their administrative expenses. It’s a good idea to try and avoid providers that charge these fees.
• Application fee: To open a merchant account, you first need to apply. In some instances, there are fees associated with the application process that the merchant account provider passes on to the merchant.
• Assessment fee: Calculated as a percentage of your total monthly sales, the assessment goes to the card associations. It’s non-negotiable.
• Batch fees: This may apply each time you settle your terminal. Inquire about the details of the batch fees and consider how frequently you batch your transactions (often daily).
• Chargeback fees: Chargebacks happen when a cardholder has been a victim of fraud. Merchant services providers will charge a fee for each instance. Multiple instances may also result in fines. According to the Federal Trade Commission, most companies pay an average of $450 to address each fraud complaint.
• Credit card payment processing rates: Fundera estimates the average card processing fees to be anywhere from 1.7% to 3.5% per transaction. Processing fees make up the bulk of the fees that you will pay to accept credit cards. Interchange and assessment fees are typically bundled into this rate.
• Equipment costs: You might already own compatible hardware. If you don’t, you’ll either need to purchase it on your own or from the merchant account provider. Many providers also offer the option to rent equipment, which may come with upfront and ongoing costs.
• Markup: Merchant services providers add an extra fee to what the card associations charge for processing. These are always negotiable.
• Minimum processing fee: Depending on your provider and selected plan, you may have to process a minimum amount in transactions. If you don’t hit this minimum, you may have to pay a fee.
• Monthly fee: A monthly fee is similar to an account or statement fee, and you’ll want to find a merchant services provider that doesn’t charge monthly fees or is willing to negotiate on them.
• NSF fee: The not-sufficient-funds fee happens when a cardholder doesn’t have enough balance in their account to cover the amount of the transaction. The issuing bank will typically apply this fee to the cardholder, so this does not impact merchants.
• PCI compliance fees: Some providers charge a fee to remain PCI compliant, though it’s advised to find one that includes PCI compliance with their cost. Non-compliance could also result in fees around $19.95 per month plus additional fines should there be a breach.
• Setup/installation fee: When you get started with a new merchant services provider, it may have setup costs. These expenses can apply both for assisted on-site and self-installations.
• Statement fee: Again, this is a hidden cost similar to account, statement, and monthly fees. The best merchant service providers do not charge statement fees.

How to Lower Credit Card Processing Fees

For starters, you can get creative and find ways to accept credit card payments online for free. But that doesn’t work for in-person transactions. Here are some ways to get lower processing rates:

• Shop around. Do your research to find out who charges the lowest rates and which fee structure works for your average transactions.
• Ask. Sometimes your current business tools can negotiate their rates for you. This works especially well if you have a long and good relationship with your merchant services provider.
• Fight fraud. Look for ways to prevent chargebacks and other fraudulent activity so you don’t waste time and money on recovery.

Credit Card Processing Security

We know fraud is the top payment-related challenge retailers face. And it’s even more costly for small businesses. Companies with fewer than 100 employees lose twice as much money as larger organizations. And unfortunately, the Covid-19 pandemic has only exacerbated this threat to businesses. Fraud rates rose by 33% as hackers sought to benefit from the increased online activity.

Luckily, there are ways you can proactively protect your business:

• Confirm the cardholder’s identity for in-person transactions with a form of photo identification.
• Use a merchant services provider and tech stack with two-way encryption, verification codes, NWS verification, and other data protection features.
• Ensure you’re PCI compliant. This will not only spare you from any non-compliance fees, but it also safeguards your business with extra protection measures in place.
• Protect your online payments portal as well as your POS. As the lines blur between traditional retail and ecommerce, it’s important to create an omnichannel experience that’s protected whatever the touchpoint.

Regardless of the measures you implement, it’s important to communicate them to your customers. They need to know how this will impact their experience, and it could give them peace of mind knowing you’re proactively protecting them.

How Chargebacks Impact Small Businesses

Chargebacks happen when a customer reports a credit card purchase as unauthorized. Sometimes this is because their card information was stolen, and other times the cardholder is knowingly involved in fraud, purchasing the item and later looking for a refund from their credit card company. In fact, the latter is one of the most common chargeback scenarios.

According to Chargeback Gurus, as many as 90% of chargebacks happen because of customer fraud or simply not recognizing the charge on their statement. Other reasons include affiliate fraud, poor customer service, and fulfillment issues.

Chargebacks cost time and money. You’ll likely have to pay a chargeback fee and, if it becomes a recurring issue, associated fines. Here are some chargeback fees from common platforms:

• PayPal: $20
• Bank of America: $25–$50
• Shopify: $15
• Stripe: $15

Many of the security tips above overlap into chargeback prevention. You can also inquire about chargeback protection from your providers, as many will offer it at a monthly cost. This mitigates ongoing fees and also handles some of the management for you.

How Payment Processing Changed for Small Businesses in 2020

Payment processing solutions continue to be more accessible for small businesses in 2020. As consumers increasingly look for ways to support small, independent merchants, providers are tasked with keeping up with the trends—and SMBs win as a result.

What Payment Processing Trends Should Businesses Expect in 2021?

1. Gift cards. According to Shopify data, gift card purchases are up. And as people look for ways to gift without shipping or seeing people in person, gift cards emerge as an easy option. Plus, many SMBs have introduced gift cards as a way to boost cash flow during periods of lockdown, so consumers and businesses alike are more accustomed to this option.
2. Payment plans. Shopify data also found an increase in consumers who make a purchase and opt for payment installments instead of paying for the item upfront. This means businesses will likely have more success with higher-priced items as they become more accessible to shoppers with all budgets.
3. NFC payments. As COVID-19 has made us all more aware of cleanliness and sanitation, contactless pay is seeing another spike. Many card readers, like Square and PayPal, already have NFC payment capabilities.
4. Fintech. Tech companies are increasingly competing with financial institutions. They now offer more than just software and hardware products. In the COVID-19 pandemic, fintech companies were more helpful to some small businesses than government aid.
5. Real-time payments. Per PYMNTS.com data, 30% of consumers factor real-time payments into their decision when choosing their financial institution, and the 70% who’ve used them would be “very” or “extremely” likely to do so again.

For more information on industry trends, read our full report The Last Click: State of Payments.

Bottom Line

Choosing the right merchant services provider for your small business is no easy feat. Though it may be tempting to go with the first one recommended to you, or the one with the lowest rates, there are other factors at play. It’s important to think about security features, tech integrations, and chargeback management. Start by identifying your unique business needs and challenges, and then rank each option against your qualifications to make an informed, strategic decision.