Credit cards are a popular payment method, and their usage continues to grow. In the U.S., credit card payments reached approximately $5.6 trillion in 2023, an 11% increase from the previous year, according to Clearly Payments.

Given the prominence of credit cards in the payments landscape, having a thorough understanding of credit card processing is important to optimizing payments solutions and managing costs effectively.

What is credit card processing?

Credit card processing is the series of steps that enable a business to securely and efficiently accept credit card payments. The process includes authorization, clearing and settlement phases and involves multiple parties, including cardholders, businesses, financial institutions and credit card networks.

Who is involved in credit card processing?

The key participants involved in credit card processing include:

• Cardholder: The individual who receives a card from an issuing bank and uses the card to make payments. This individual can be either the card owner or an authorized user of the card.
• Issuing bank: The entity, also known as a card issuer, that underwrites and issues cards to individual and business cardholders who meet certain credit standards. The issuing bank maintains card accounts, bills and collects payments from cardholders and monitors the performance of credit card receivable portfolios.
• Merchant: A business that accepts cards as a method of payment. These payments can be made in person, online, or by mail order or telephone.
• Merchant bank: The entity, also known as an acquiring bank, that maintains the merchant’s account where deposits from credit card payments are accepted. Some merchant banks also provide merchants with credit card terminals, which may be purchased or leased.
• Payment processor: The entity that helps many merchants and merchant banks manage the daily settlement and information flows related to credit card activities.
• Issuer processor: The entity that provides a system for issuing banks to board accounts, provides authorizations and offers risk management tools to issuers to manage their card portfolios effectively.
• Card network: The organization, also known as a card association, that maintains infrastructure to support card transaction activities such as authorization, clearing and settlement. Examples of card networks include Visa, Mastercard, Discover and American Express.
• Payment gateway: The technology that provides the link between the point at which the credit card data is received by the merchant and the merchant bank. The payment gateway encrypts the data before sending it to the merchant bank and transmits both the authorization request to the issuing bank and the issuing bank’s response back to the merchant.

How does credit card processing work?

Credit card processing happens in three phases: authorization, clearing and settlement.

Authorization

The first phase is credit card authorization, which typically only takes a few seconds.

1. A customer pays for a purchase with a card at a point-of-sale (POS) terminal in a store, online or by mail order/telephone order (MOTO).
2. The merchant submits an online authorization request for the charge amount to the merchant bank. This request is usually transmitted through a POS terminal or payment gateway.
3. The authorization request is routed through the appropriate card network to the issuing bank.
4. The issuing bank reviews the cardholder’s account and approves or declines the transaction. If the transaction is approved, the issuing bank places a hold on the cardholder’s credit limit for the amount of the charge.
5. The issuing bank sends the approval or denial back through the card network to the merchant.

Clearing

The second phase is the clearing process, which is how payment information is communicated through the card network.

1. The merchant electronically sends batches of authorized card transaction data to the merchant bank, typically at the end of the business day.
2. The merchant bank forwards the transaction data through the card network to the issuing bank.
3. The issuing bank receives the transaction data and converts the hold on the cardholder’s account to a charge that will appear on the cardholder’s monthly billing statement.

Settlement

The final phase is the settlement process, which typically occurs the day after the clearing transaction is submitted to the card network.

The card network establishes the net positions of all settlement participants (i.e., issuers and acquirers), collects funds from the issuing bank and transfers the funds to the merchant bank.

For cross-border transactions involving more than one currency — such as when a card issued in one country is used for purchases in another country — foreign currency exchange is handled as part of the settlement process.

The merchant receives either a gross settlement or a net settlement. In the case of a net settlement, the merchant receives the transaction value minus fees. In the case of a gross settlement, the merchant receives the full transaction value and is periodically invoiced for the fees due to the various parties.

Credit card processing fees

When businesses accept credit card payments, they incur credit card processing fees, which vary in amount depending on the type of card, transaction volume and payment processor.

The three main categories of credit card processing fees are:

• Interchange fees: These are fees merchants pay to issuing banks to cover the costs of issuing cards and processing card transactions. Card networks set these fees.
• Assessment fees: These are fees merchants pay to card networks to help cover their operating costs. Card networks also set these fees.
• Payment processor fees: These are fees merchants pay to their payment processor (often the merchant bank or a third-party processor) for facilitating the transaction. Payment processors set these fees, which may be a flat fee per transaction, a monthly fee or a percentage of the transaction amount.

Beyond these three main fees, some payment processors charge an annual fee for maintaining payment card industry (PCI) compliance or helping the business achieve compliance.

Additionally, while not a fee, the costs associated with leasing or purchasing card readers or POS terminals are an important consideration for businesses that need to accept in-person payments.

Credit card disputes

Cardholders typically have 60 to 120 days to dispute a charge assessed to their accounts. A successful dispute will result in a chargeback, which returns funds from the purchase to the cardholder. Merchants may also be required to pay a chargeback fee.

Merchants have a set period of time to respond to a dispute, provide evidence that the charge is valid and have the merchant bank present the charge again. However, if a chip card was used at the point of sale but was not processed via EMV (Europay, Mastercard and Visa), the merchant will receive the chargeback without being able to dispute the charge.

Merchants should retain copies of all merchant agreements with payment processors and maintain secure records of all transactions to ensure compliance with the agreements' terms and conditions. These records also serve as evidence of transactions in the event of a dispute.

Credit card processing best practices

Following best practices for processing credit card transactions can help businesses avoid potential fines, protect against payments fraud and improve customer satisfaction.

• Maintain sufficient funds to cover processing fees. Otherwise, an account could be sent to collections, and collections fees would be incurred.
• Reconcile deposits regularly to identify and resolve discrepancies quicker.
• Avoid excessively retrying a declined card. Repeatedly attempting to make a transaction with the same card can lead to authorization issues; instead, instruct staff to request an alternative payment method from the customer.
• Respond promptly to chargebacks. Merchants are given a limited amount of time to respond to chargebacks, and failure to respond in time could result in the merchant losing the case.
• Monitor and analyze transaction history to detect anomalies that might be signs of fraud and identify trends that could inform payment processing strategies.
• Maintain compliance with the Payment Card Industry Data Security Standard (PCI DSS). This worldwide information security standard, defined by the Payment Card Industry Security Standards Council, helps prevent fraud through increased controls of the data held and exchanged by businesses that process card payments. Using a PCI-compliant payment processor can simplify the compliance process.
• Equip POS terminals with EMV chip readers. EMV chip transactions are more secure than transactions using a magnetic stripe, as EMV technology encrypts transaction data.
• Implement point-to-point encryption (P2PE) and tokenization. With P2PE, payment data is encrypted at the point of sale and can be read with the appropriate key. Alternatively, tokenization can be used to minimize data breach risks. Tokenization allows the cardholder to make a payment without providing card or bank account information to the merchant.
• Educate staff on secure processing procedures, including proper handling of card transactions and recognizing signs of fraud.