What Is a Merchant Account and Do You Need One to Accept Credit Card Payments?
If you want to accept credit and debit cards from your customers – and virtually every business needs to these days to remain competitive – you likely, but not necessarily, need access to a merchant account. “Merchant” is another word for a seller or business owner. You can think of a merchant account as a bank account that extends you, the merchant, a line of credit. This allows a merchant to receive funding for the credit transaction based on the trust that they will perform the services or deliver the goods properly, and thus the customer will not refuse to pay for the transaction based on the inadequacy of the merchant.
While a merchant account is usually the most reliable way to accept credit card payments, the truth is that you can take cards without one by using a third-party payment processor. We discuss the differences between a third-party processor (also known as a payment services provider) later on in this guide. If you truly want the easiest and quickest method for taking credit cards, then accepting payment on your smartphone (whether an iPhone or Android) via a service like Square (read our review) might be what you’re looking for. But it does come with tradeoffs, which we’ll discuss.
The point of a merchant account is to facilitate the complex interactions that need to occur between you, your customer, the credit card networks, and your payment processor every time you receive a card payment. (Accepting credit cards is tricky business!) It helps to ensure that you receive funding as quickly as possible, that the banks are protected from losses, and that buyers are protected from ripoffs and scams. With a merchant account, everyone is held accountable based on the rules of the credit card processing agreement.
You will, of course, have to pay a number of fees in order to take advantage of the credit card processing networks and banks. But it’s much easier and more secure to open a merchant account than it is to keep a book of credit accounts for all of your customers!
Quick Guide: How to Avoid Merchant Account Scams and Ripoffs
Be skeptical of sales gimmicks: If it sounds too good to be true, it probably is. A lot of processors make claims about having the lowest rates in the industry, but how can they all have the lowest? Answer: they can’t. They will match the rate quote provided by another processor, but the contract could still include hidden fees to make up for it. When a processor claims that it will pay you $1000 if it can’t beat a competitor’s quote, rest assured it has no intention of paying up. There’s always a loophole.
Request interchange-plus pricing: The only way to make real, meaningful comparisons between rate quotes is to get an interchange-plus rate. This type of quote will tell you the markup that you are paying on top of the wholesale (or “interchange”) cost of the transactions. Since the wholesale cost will vary from transaction to transaction, this is the only way to get a clear picture of the profit margin for the processing company. Fixed rate tiered quotes that do not separate wholesale from markup reduce transparency and make it impossible to compare the rates effectively from one company to the next.
Avoid early termination fees: The most common merchant account fee that we see complaints about is the early termination fee (ETF). These fees can range from hundreds to thousands of dollars, and are often not disclosed or poorly disclosed during the sales and contract signing process. Don’t take your salesperson’s word for it, either. Verbal promises during the sale process are not legally binding. If it’s not in writing, it’s worthless. You need to review your contract carefully and make sure an early termination fee waiver is included if the contract mentions an early termination fee.
Don’t give in to pressure: Some merchant account sales agents will try to put pressure on you to make a quick decision, saying that an offer is only good for a certain amount of time. Never let these high-pressure sales tactics sway you. You, the business owner, have all the power. Don’t make any hasty decisions. Sales agents may also try to make you feel like you owe them something just because they have spent time on you. You don’t owe the sales agent anything! Don’t let them guilt you into making a decision that could negatively impact your small business for years to come just so they can close a sale.
What Is a Payment Gateway and Do You Need One to Accept Credit Card Payments Online?
A payment gateway provides the connection between an online payment and the bank that processes any given credit or debit card transaction. Whether used for eCommerce or a mobile payment application, the payment gateway works behind the scenes to securely transfer sensitive credit card information. It’s important to recognize that a gateway is not the same thing as merchant account, and each comes with its own separate fees. An internet merchant account will be a combination of payment processing service and gateway service.
Most eCommerce businesses will need a (see our top payment gateway picks), but some in-person businesses might need one too. Point of sale (POS) software will sometimes require a payment gateway to operate. If you just need a virtual terminal to key-in card information at your computer, however, you might not need a dedicated gateway at all. Many payment processors include a virtual terminal for free as part of their basic service packages.
Some services — like Stripe and PayPal — bundle a third-party processing account with a payment gateway in order to make the service as inexpensive as possible. While it certainly helps keep costs down, there are downsides in terms of stability. We take a look at some the trouble that can come from processing payments without a merchant account in this guide.
To use a payment gateway, you will have to “integrate” it with your website or software. This can be as easy as typing in a numerical key. It can also be difficult enough that you will have to hire a web developer to help out. It all depends on your gateway, your software, and your needs. Your gateway provider’s website should include detailed instructions regarding integration.
When picking a payment gateway, it’s important to make sure that it’s compatible with your POS, your shopping cart, or your payment processor. Not all gateways work with all systems. Be sure to talk to customer service before you commit to any solution to avoid fees and penalties for canceling.
Quick Guide: How Credit Card Processing Works
Whether you’re a new merchant looking to accept credit card payments for the first time or a seasoned veteran trying to figure out if your current provider is really giving you a good deal, it’s essential that you understand how payment processing and the processing industry work. Without basic knowledge of all the moving parts and how they fit together, you will be at the mercy of every fast-talking sales representative who wants to convince you that his or her company is the best one for you.
Besides understanding what happens when a credit card transaction is processed, you’ll also want to know who the various players are in the merchant services industry, as well as what a merchant account provider can – and can’t – do for you. Sales agents tend to make unrealistic promises, and it’s important to recognize when it happens to you.
Companies Involved In Card Payment Processing
It would be convenient if everything involved in credit card processing were handled by a single, monolithic entity. Unfortunately, this is not the case. The company that provides your merchant account is just one of many companies involved. Below is a brief explanation of the essential business entities involved in facilitating your ability to accept credit cards and what functions each performs.
Merchant Services Providers (MSPs)
A merchant services provider (MSP) is sometimes referred to as a merchant account provider or independent sales organization (ISO), and somewhat less commonly as a sub-ISO, sub-MSP, merchant level sales (MLS), value-added reseller (VAR), or simply a reseller. While there are some nuances to the meanings and usage of these terms, they all essentially refer to the same types of entities. We will use the abbreviation MSP in this workbook when we reference this type of entity.
In case you’re a stickler for precision: What we call an “MSP” in this guide is more accurately defined as a sub-MSP working under a larger “acquirer” MSP, which we’ll get to momentarily. Yeah, it’s confusing. But don’t worry – we have a chart later on to help.
The MSP’s primary function is to set up and maintain your merchant services and agreements. It handles the application process, sets pricing for your account, and formalizes the contract that will define the relationship between your small business and the other entities involved in processing payments.
Merchant services providers will often set up any additional services required by your particular business, sometimes called value-added services. These services may include payment gateways and virtual terminals for e-commerce and phone order merchants to accept credit cards online, or credit card terminals and point of sale (POS) systems for retailers. MSPs may provide customer service for some account-related issues, but when something goes wrong with a transaction, you will often be passed along to the payment processor (which we’ll get to next).
This is the first company you’ll have to deal with in setting up your account, as all contract terms and pricing must be negotiated with the MSP. It will remain your first-order point of contact for all things related to your merchant services.
Payment Processors & Acquirers
Payment processors provide the behind-the-scenes framework to securely process your card-based payments. A merchant services provider is said to be a direct processor if it provides both the merchant account onboarding as well as the processing services. Only large and well-established companies tend to have the resources to do this. In most cases, an MSP sets up and maintains the merchant account, but utilizes the services of other companies to handle the payment processing itself.
The term acquirer tends to refer to a larger MSP, usually with in-house payment processing capabilities and several branded software products. This is the company for which a smaller sub-MSP (just “MSP” for our purposes, as mentioned earlier) “resells” services.
While the payment processor and the acquirer might actually be separate entities (and in fact the processing responsibilities alone might be divided between two companies, even within one transaction!), we will conflate these companies here for simplicity’s sake and call this entity the “payment processor.” The simple distinction is that the processor moves around the information for authorization and settlement, while the acquirer handles the merchant accounts. (It “acquires” merchants for the credit card networks.)
Are you following so far? The MSP is the smaller company focused on dealing with business owners directly, and the payment processor is the larger company that tends to operate in a more behind-the-scenes capacity.
Distinctions between merchant service providers and payment processors are fuzzy, depending on who you ask. The term “payment processor” is often used to describe any company that sets up merchant accounts or payment processing services. To make matters more confusing, you might see either of these entities referred to as an acquirer. The truth is that it’s a very complex system with imprecise definitions. One company can perform several roles at once or it can split up responsibilities among many partner companies. As far as you are concerned, none of that really matters. What you need to know is that when you sign up for a merchant account, you are likely becoming involved with several companies, not just the one that sets up the account.
For our purposes, the MSP is a sub-company that issues merchant accounts from a larger company. The “processor” is the larger company. The processor can set up a merchant account on its own using its own sales staff and marketing department. By using independent merchant services providers to issue accounts, however, it expands its range.
You Might Be Thinking: “I bet bigger processors provide better value.” While you might think that a big processor will get you a better deal than a smaller merchant services provider, this is not often the case. You are not actually cutting out a middleman when you go “direct.” You are just choosing a different middleman, and often a worse one. The sales staff and merchant acquiring division at the big processor need to get paid, just as those same people at a smaller company do. And, unfortunately, the standardized pricing terms provided by the bigger companies tend to be over-inflated. You are left to negotiate, and you will have to negotiate carefully. Good contract terms, like waived termination fees, will not likely come standard.
When you sign up with a high-quality merchant services provider, however, you get a contract and pricing package that are interchange-plus, provide a standardized baseline rate, and openly disclose all fees up front. We like to call this type of pricing arrangement “pre-negotiated” because the company has already done the work of assessment and disclosure for you. The company might include additional products and services that create even more value for you, alongside everything offered by the big payment processor. Your money is still handled by that big, reliable company behind the scenes. You get support and extra attention from the smaller company, but you also have access to all of the support and tools offered by the bigger company. Ideally, you get the best of both worlds.
Credit Card Brands
Credit card brands organize the processing networks, define interchange rates (the biggest part of your transaction rates – we’ll talk more about that later), and dictate the usage rules for their cards. In the United States, Visa and MasterCard are the two most popular and well-known credit card companies. When setting up a merchant account, you enter into peripheral agreements with these companies. Some smaller card brands, like American Express, are opt-in, meaning that you decide whether or not you want to accept them and enter into their agreements.
An issuing bank (or “issuer”) is simply the bank that issues the credit card to the customer. Issuing banks are involved in credit card processing because they are the entity that extends the credit to the customer when a credit card is used to make a purchase. Visa- and MasterCard-branded cards—such as a Bank of America Visa card—will be issued by a specific issuing bank. As a merchant, you will rarely interact with an issuing bank unless there is a dispute over a transaction or an authorization issue. Even then, the process between you and the card issuers is arbitrated via your MSP. (Note that chargeback disputes are a pain, but a necessary evil if you want to accept credit cards.)
These financial institutions back the MSPs and allow them to open merchant accounts on behalf of the merchant. The sponsor bank relationship enables a connection with the cardholder’s bank (the “issuing bank”) via the payment processor. You won’t have to deal with your MSP’s sponsor bank, but it’s good to be aware of this entity to avoid confusion during your research.
A payment gateway helps with processing transactions for online business. It connects the merchant’s website to the payment processor for the purpose of authorizing a transaction (making sure the card number and information are valid so that the transaction can be approved). Some point of sale systems might require merchants to use a payment gateway for in-person transactions, but as a rule, gateways are needed only for web-based sales.
Merchant Services Provider
Independent sales organization, ISO/MSP, sub-ISO, sub-MSP, MLS, reseller, VAR, acquirer
We call this company the MSP in this guide. It sells merchant accounts and services directly to merchants.
Processor, ISO/MSP, backend processor
For our purposes, we refer to this entity as the payment processor to differentiate it from smaller sub-companies. Technically, it is a type of MSP. It sells merchant accounts and services directly to merchants and/or manages various sub-MSPs that sell directly to merchants.
Front-end processor, back-end processor
We lump the acquirer and the processor together, as they are often part of one company. It moves transaction information between the sponsor bank and the issuing bank to authorize (front-end) and settle (back-end) card payments. It may be part of the same company as the MSP.
Merchant bank, acquiring bank, settlement bank, processing bank, BIN bank
This bank backs the MSP. It communicates with the issuing bank via the processor to facilitate card payment transactions.
The issuing bank backs the cardholder and issues credit cards. It communicates with the sponsor bank via the processor to facilitate card payment transactions.
This service connects a website to the card payment network for transaction authorization.
Credit card networks, card associations
These companies set the rules and standards for card usage. Additionally, they provide the infrastructure for standardized and effective processing and issuance.
If you feel like these distinctions are going in one ear and out the other, don’t worry too much about it. This stuff is confusing. Just remember this:
Going with the biggest company won’t necessarily get you the best rates or service.
Even if your merchant account is from Acme Processing, you might see the name of a different, larger company on your processing statement and you might get your customer support from that larger company as well, in some cases.
There are many entities involved in processing payments, each with its own interests and rules that can affect your business.
How Do Third-Party Processing and Smartphone Payment Service Providers Work?
Everyone wants to know about mobile processors (like Square) and easy to use online processing systems (like PayPal). What are they? How do they work? Are they the same as merchant accounts? Okay, fine. Want to know the secret behind these companies’ payment processing? It’s a rarely discussed bit of industry knowledge. When mobile processors first hit the scene, we had to wonder how the heck these services could possibly set up merchant accounts so fast with no setup fee and no monthly fees, and why they had so many pitfalls as well. The idea of accepting card payments with a free credit card reader paired any old smartphone — and no monthly fee for the merchant account — seemed too good to be true. It turns out that they don’t actually set up merchant accounts. So how do they process payments, then?
With payment service providers (PSPs), you have indirect agreements with the processing companies. The PSP is a middleman. Instead of opening an account just for you, a PSP will funnel your transactions, along with hundreds or thousands of other users, through shared accounts. In 2011, Visa expanded and redefined its internet payment service provider (IPSP) model to include sales to traditional merchants, which allowed for in-person mobile payments. Thus, the classification was renamed simply payment service provider and enabled in-person payments to process under this designation.
Providers like PayPal had been aggregating internet-based payment service for years to make accepting credit card payments as easy and cheap as possible for a small home-based business. But bringing that same model to physical sales – that was a novel service. MasterCard also uses the term payment service provider, but Discover uses payment facilitator to mean the same thing. You will also see the terms third-party processor (TPP/3PP) or merchant aggregator used to describe this same dynamic. The result of this redefinition? A huge boom in low-cost, in-person payment processing.
Low-cost sounds great, but it has its limitations. While a merchant account provider has an in-depth, intensive application and underwriting (risk determination) process, PSPs do not. The result is that merchant accounts tend to be very stable, while PSP accounts tend to be subject to sudden account terminations and funding holds. You definitely do not want to use a PSP in place of an offshore merchant account.
When to Use a Payment Service Provider
If you plan to process a very low volume in cards ($5K or less per month), you should definitely consider processing through a payment service provider. While processing rates might be a little higher than if you had your own merchant account, PSPs usually do not charge a monthly fee or other scheduled fees. You just pay for what you use, which is ideal for businesses that only process sporadically. You will have to make peace with the potential for account terminations and funding holds, especially for those working in high risk industries where customers are prone to dispute charges. We recommend that these merchants check out our list of the top high-risk merchant accounts instead, especially if they’ve been rejected by other payment processors in the past.
Still not sure what you need? This chart should make it clear:
Payment Service Provider
Lowest for mid- or high-volume businesses, usually negotiable
Lowest for lower-volume businesses, usually non-negotiable
Sometimes includes software or hardware at no additional cost
Always includes basic business software at no added cost along with low-cost hardware
Can take days
Usually instant approval
Account terminations and funding holds are uncommon
Account terminations and funding holds are somewhat common and difficult to predict
Usually high-quality, including dedicated account manager
Usually self-service, with little or no quality phone-based support
Works with a variety of third-party hardware and software
Works with a limited selection of usually proprietary hardware and software
Should have no early termination fee, but might have setup/closure costs
Almost never has an early termination fee
Not sure whether the processing company you are looking at is a merchant account services provider or a PSP? Here’s a quick tip: If there is no monthly service fee, it’s probably a PSP. Some PSPs do charge a monthly service fee, but most either will not or else will provide a feeless option alongside an option with a fee. There are exceptions, but this is a pretty good bet.
How to Accept Mobile Payments
Here’s an important distinction. Mobile credit card processing (accepting card payments on a smartphone or tablet) is not the same as accepting mobile payments. “Mobile payments” refers to phone-based digital wallets like ApplePay, Android Pay, GooglePay, ChasePay, MicrosoftPay, Bitcoin wallets, and so on. You don’t need a mobile iPad or iPhone POS system to accept these forms of payments (although mobile processing systems can accept mobile payments). Yes, I know this is confusing. I didn’t invent the terminology, so don’t blame me. We have a comprehensive guide on accepting mobile payments that you should check out if you’re interested in so-called “near-field communication” (NFC) payments.
How To Accept ACH/EFT/eCheck Payments
A lot of people believe that bank account transfers are under the domain of merchant accounts. This is not true. A completely different service must be set up to do ACH (automated clearing house) payments. Some people call this EFT (electronic fund transfer) or eCheck (electronic check, in case it’s not obvious). We have a whole separate post about accepting ACH payments.
There’s another important distinction within this topic. Credit card processing is not exactly synonymous with payment processing. The truth is that credit card processing is a type of payment processing. You can read more about this in our in-depth guide to payment processing.
Credit Card Machines and Card Readers
If you want to accept credit card in-person securely, you’ll need a credit card reader or a credit card machine (terminal). A card reader is a little device that connects to a smartphone or tablet. Some providers even offer them for free. A credit card machine, on the other hand, is a larger device that usually includes some features a reader will not, such as a built-in receipt printer, a PIN pad, and the ability to use a direct internet or phone connection. Credit card readers are usually at the whim of Wifi or cell phone service, which can be problematic. If you go to machine route, it’s important that you never lease the terminal, as this is a well-known tactic used by merchant service providers to make thousands of dollars for a machine that only costs a few hundred, even for a reader that does EMV chips and NFC contactless payments as well as ordinary swipes for magstripes.
Didn’t find what you need here? Well, some of this text was adapted from our Beginner’s Guide to Credit Card Processing, so we’d recommend that you take a look at the complete guide for more information. And for the ultimate guide to credit card payment processing, take a look at our comprehensive workbook, which also helped inspire this page.