The Truth About Third-Party Payment Processing
So, you’re all set to launch your new business and make your fortune (well, hopefully). You realize that it would be nice if your customers could pay you using their credit and debit cards. Okay, “nice” isn’t nearly a strong enough word to describe how desirable this option is. In today’s increasingly cashless society, it’s flat-out essential for most businesses to be able to accept credit cards. Without that ability, retail companies will lose out on sales, and eCommerce businesses will have a hard time making any sales at all.
You realize that you’re going to need a merchant account to process your credit and debit card transactions. But where do you find one? Every provider you talk to wants a ton of information about your business, tells you that they have the lowest rates (without mentioning what they are), and tries to pressure you into signing a lengthy contract before you’ve even had a chance to read it. Then you hear about Square (see our review). No lengthy contracts. No endless forms to fill out. No monthly fees. Rates that are published right on their website. What kind of black magic is this? It all seems too good to be true.
Square – and other companies like it – are what are known as third-party processors. Rather than giving you your own merchant account, they oversee a giant merchant account that’s shared by all their users. In this article, we’ll explain how third-party processors work and how they differ from traditional merchant account providers. We’ll also explain the advantages and disadvantages of using a third-party processor rather than signing up for a full-service merchant account. Finally, we’ll give you some examples of popular third-party processors that are helping businesses just like yours every day.
How Third-Party Payment Processing Works
First, let’s discuss nomenclature for a moment. The credit card processing industry is notorious for using different, non-standardized terminology to describe the various entities you’ll encounter when you set up a merchant account for your business. While there often isn’t a single, “correct” term that must be used, you’ll find certain terms are more commonly used than others.
The most broadly-defined term you need to know is merchant services provider. This is any business entity that can help you process credit or debit card transactions – regardless of how they do it. Breaking this down a little more, there are two types of merchant services providers:
- Merchant Account Providers (MAPs): These companies will set you up with a traditional, full-service merchant account. Your account will include a unique merchant identification number that identifies your business to the payment processing networks. There are dozens – if not hundreds – of merchant account providers on the market, many of whom are resellers for a small group of very large direct processors. Examples include Payment Depot and Fattmerchant.
- Payment Service Providers (PSPs): These companies provide you with the ability to accept credit and debit card payments, but don’t offer a true merchant account with a unique merchant identification number. Instead, your account will be aggregated with that of other businesses using their service. Although there are relatively few PSPs in the industry, they’ve garnered a large share of the processing market in recent years by offering a low-cost solution to small business owners. Examples include Square, PayPal, and Stripe Payments.
While the term merchant account provider is very commonly used, things get a little fuzzy when it comes to payment service providers (PSPs). Although both Visa and Mastercard officially use the term payment service provider, you’ll also commonly hear them called third-party processors, aggregators, and even payment facilitators. You just need to understand that all these terms refer to the same thing: a company that can allow you to process credit and debit card transactions without the need for a full-service merchant account. For a more in-depth look at payment service providers and how they operate, check out our article, What Is A Payment Service Provider?.
Third-Party Processors VS Merchant Accounts
Before you decide that a third-party processor is a good choice for your business, you need to understand how they differ from traditional merchant account providers. Here’s a rundown of the main differences you’ll encounter between these two types of business entities:
- Simplified Underwriting: Traditional merchant account providers need to collect an extensive amount of information about your business before they can approve you for an account. This process can take several days – or even weeks. Third-party processors already have an aggregated merchant account that you can be added to, so they don’t need nearly as much information upfront. They can usually approve you in fewer than 24 hours, and in many cases, the application process can be completed entirely online. For this reason, third-party processors are often a great choice for new businesses that don’t have an established processing history yet.
- Account Stability: The downside to quick and easy approval is that it’s just as easy for your account to be shut down. Square, in particular, has a bad reputation when it comes to account stability. Account holds, freezes, and terminations can happen unexpectedly for a number of reasons. Perhaps the most common cause is when a business attempts to process a single transaction that’s much larger than what they’ve averaged previously. Similarly, Square will shut you down quickly if they determine that you’re a high-risk merchant.
- No Long-Term Contracts: While your relationship with your processor will always be governed by a contract of some type, Square and other third-party processors don’t require you to keep your account open for a specified length of time. Merchant account providers, in contrast, frequently require you to accept a long-term contract (typically for three years) with an automatic renewal clause that extends your contract for one-year periods and an early termination fee (ETF) that you’ll have to pay if you break your contract by closing your account early. While these provisions are more or less the industry standard, they’re very unpopular with merchants. As a result, there is a growing number of merchant account providers who have ditched the long-term contracts and allow you to maintain your account on a month-to-month basis.
- Pay-As-You-Go Billing: Unlike merchant account providers, who typically charge a number of monthly and annual fees in addition to your processing charges, third-party providers usually only charge you for the cost of processing your transactions. You usually won’t have to pay a monthly account fee, an annual fee, PCI compliance fees, or gateway fees. The tradeoff is that your processing rates will usually be significantly higher overall than what you’d pay under an interchange-plus pricing plan offered by a traditional merchant account provider.
- Simplified Processing Rates: Most third-party processors offer simplified, flat-rate pricing for processing your transactions. Everyone pays the same rates, and they’re published right on the provider’s website. This makes it much easier to know in advance what your overall costs will be so that you won’t get hit with any sudden surprises on your monthly billing statement. However, you should be aware that flat-rate pricing rates are notably higher than most interchange-plus rates, particularly for PIN debit transactions. At higher monthly processing volumes, this can actually make using a third-party processor more expensive than a traditional merchant account.
- Customer Service Options: Third-party processors aren’t known for offering a full range of ways to contact customer service. Instead, you’ll often find yourself rummaging through an FAQ on their website or trying to contact them via email. This situation is gradually getting better, with some third-party processors now offering telephone-based customer support where you can talk to an actual human being.
As we’ve noted previously, both third-party processors (or payment service providers) and traditional merchant account providers fall under the term “merchant services providers,” as they’re both able to process your transactions and deliver the funds from those transactions to you. However, it’s essential to consider the differences between these two types of entities and to understand how those differences could affect your particular business.
Can I Really Accept Credit Card Payments Without A Merchant Account?
The upshot of the above discussion is that, yes, you can take credit and debit cards without having to sign up for a full-service merchant account. Third-party processors such as Square or PayPal give you the ability to process these types of transactions without the expense and paperwork of setting up a merchant account. For a new business that’s just getting off the ground, this can be a great option. You’ll save money on fees, and you’ll be able to start taking credit card payments much quicker than if you had to go through the full underwriting process that getting a merchant account requires.
However – and we can’t emphasize this point enough – third-party processors are not the best choice for every business. Both third-party processors and full-service merchant accounts have their good and bad points, and you need to understand them and determine how they affect your business before deciding on which type of payment processor to use. Below, we’ll discuss the advantages and disadvantages of third-party processors, and how you can evaluate which kind of processor is right for your business.
Advantages of Third-Party Payment Processing
Here’s a look at the benefits of using a third-party processor for your business:
- Quick Setup: Square and other third-party processors allow you to sign up for an account online, and you’ll usually be approved in little or no time. Just download the Square app and log in, and you can start accepting cards instantly. (Note that you’ll need to wait for your card reader to arrive in the mail before you can accept card-present transactions.) This feature is in marked contrast to the underwriting procedure that a merchant account requires, which can take days or even weeks to complete. The flip side is that your account won’t be as stable as a true merchant account, and you’ll have to be very careful to avoid any account holds, freezes, or terminations.
- Technology-Driven Platforms: In our experience, there is a fundamental cultural rift between third-party processors and traditional merchant account providers. Third-party processors tend to be established and run by people with computer science degrees and deep tech backgrounds. Merchant account providers, however, are usually run by bankers with business degrees who aren’t really experts in modern computer technology. While they offer most of the same software products (such as payment gateways, virtual terminals, etc.) as third-party processors, they often rely on outside contractors to develop them, as they don’t have the same level of in-house expertise that you’d find with a third-party processor. This rift is slowly closing, but for now, you’ll still find that third-party processors offer products that are more automated, more integrated into cloud-based platforms, and more feature-rich than what most merchant account providers can give you.
- Low (Or No) Initial Setup Costs: If you just need a payment gateway or a magstripe-only card reader for your smartphone, account setup with Square is essentially free. Although we highly encourage you to part with a few dollars and purchase the company’s EMV card reader, this cost is still a fraction of what you’ll pay to get started with a full-service merchant account. Application fees, account setup fees, and paying for a credit card terminal can all add up to hundreds of dollars, depending on the provider. Fortunately, competition from third-party processors is forcing merchant account providers to lower (or even eliminate) many of the costs associated with establishing a merchant account.
- No Monthly Fees: Perhaps the most attractive feature of third-party processors to small business owners is that they (usually) don’t charge any monthly fees to maintain your account. Monthly account fees, statement fees, PCI compliance fees, and annual fees are all eliminated. You also won’t have a monthly minimum hanging over your head every month. This makes third-party processors particularly affordable to very small businesses that don’t have a high monthly processing volume. Also, seasonal companies won’t have to worry about being charged during the months when they’re not operating at all.
- Predictable Flat-Rate Pricing: It’s nice to know in advance what it will cost you to process a transaction, and third-party processors make this easy to do with their simple flat-rate pricing plans. With this type of pricing, you can also more accurately estimate your monthly processing costs, meaning that you shouldn’t have any unpleasant surprises waiting for you on your monthly processing statement.
- No Long-Term Contracts: Third-party processors only charge you for actually using your account, and you won’t be locked into a lengthy contract. You also won’t have to worry about getting hit with an early termination fee if you close your account. Note that an increasing number of traditional merchant account providers are now beginning to offer this feature as well, so you don’t necessarily have to sign up with a third-party processor to avoid getting locked into a long-term contract anymore.
- Free Hardware: When Square first launched in 2009, one of its most attractive features was that each account came with a free magstripe card reader that plugged into your smartphone or tablet. Together with the Square app (also free), you could log in and start accepting credit card payments right away. In contrast, most merchant account providers at the time would either sell you a credit card terminal for a few hundred dollars or sign you up for an expensive terminal lease that would ultimately cost you even more. While Square’s magstripe reader is still free, it’s also obsolete. We highly recommend purchasing the company’s EMV-capable reader, which costs far less than a standalone terminal.
Disadvantages of Third-Party Payment Processing
Okay, if third-party processors are so great, why isn’t everyone using them? Why are full-service merchant account providers still in business? The answer, of course, is that third-party processors also come with some significant limitations that make them a poor choice for a lot of businesses. Before you rush out to sign up for your “free” third-party account, consider some of the following disadvantages:
- Account Stability Issues: Not having to go through the complete underwriting process makes it quicker and easier to get up and running, but it also means that your account isn’t as secure as an individual merchant account. While having a full-service merchant account doesn’t provide complete protection from account holds, freezes, and terminations, it does make them much less likely. Consider the potential impact of an account freeze on your business before you sign up with a third-party processor. In our experience, these unfortunate incidents usually occur because either (1) the merchant attempted to process a much larger transaction than their average ticket size, or (2) the processor discovered that the merchant was selling something that’s expressly prohibited by their user agreement. This includes most high-risk businesses, including CBD merchants.
- No Specified Processing Limits: With a full-service merchant account provider, you’ll be required to stay within maximum monthly processing limits and maximum transaction sizes. Third-party processors, unfortunately, tend not to specify what these limits are in advance. You’ll only find out that you’ve gone over a limit when you actually exceed it and suddenly have your account shut down. While the majority of merchants using third-party processors never experience this problem, it’s still important to consider it before you sign up.
- Limited Acceptance For Specialized Cards: Third-party processors generally don’t allow you to accept specialized cards such as SNAP/EBT cards or government-issued credit cards. Debit cards are generally accepted, but you’ll pay much higher processing rates than you would under an interchange-plus pricing plan offered by a traditional merchant account provider.
- Limited Hardware/Software Options: With so many credit card terminals, POS systems, payment gateways, and online shopping carts on the market, traditional merchant account providers go to great lengths to ensure that their accounts are compatible with as many of these products as possible. With a third-party processor, you’ll usually be limited to using just the hardware and software products that your processor offers – and these are often pretty generic. This might not be much of an issue for a small business owner, but as your business grows, you’ll eventually want to add many of the bells and whistles that are available with a full-service merchant account provider.
- Expensive Flat-Rate Pricing: Wait a minute. Didn’t we just say that third-party processors were less costly than full-service merchant accounts? Well, that’s only true in some circumstances. For a very small business owner, you’ll usually save money with a third-party processor because you won’t have to pay all the extra monthly and annual fees that come with a full-service merchant account. However, flat-rate pricing is significantly more expensive than interchange-plus pricing, at least on a per-transaction basis. Debit card transactions, in particular, are dirt cheap under interchange-plus pricing. With a flat-rate pricing plan, however, you’ll pay the same high rates for debit cards as you will for credit cards. You’ll want to carefully analyze your overall costs under each type of pricing before deciding which option is best for your business.
- Limited Customer Service Options: Square – like many other third-party processors – is notorious for offering limited options for customer support. For a long time, Square didn’t even have a phone number that you could call for help! Customer support was often limited to email, which was slow and required a lot of back-and-forth messages to resolve an issue. Merchant account providers, however, usually offer 24/7 telephone support. Unfortunately, the quality of that support can vary widely from one provider to another.
Is Third-Party Payment Processing Right For Me?
By now, it should be quite clear that the choice between a third-party processor and a traditional merchant account will depend on the nature and size of your business. There isn’t a single provider on the market that offers a true “one size fits all” service that’s suitable for every business. Third-party processors are usually a great choice for very small or seasonal businesses that don’t process a lot of credit card transactions, don’t have a high monthly processing volume, and don’t need any of the fancier bells and whistles that are available with a merchant account.
Ultimately, your overall processing costs will determine whether you should sign up with a third-party processor or go all-in with your own merchant account. Whichever option meets your needs for the lowest cost will, naturally, be the best choice. Unfortunately, it isn’t always easy to accurately determine which option will save you the most money. As a very general rule, we usually recommend third-party processors to small businesses and merchants who are just starting out. In contrast, larger, more established businesses will usually save money with a traditional merchant account.
Typically, the single most important factor in making this determination is your monthly processing volume. Unfortunately, there are so many variables involved that we can’t provide a specific amount where it makes sense to upgrade to a full-service merchant account. We’ve seen figures from vendors ranging from as low as $1,500 per month to as high as $10,000 per month. The important thing to understand is that this number is highly variable and unique to your business. You’ll have to compare quotes from several merchant account providers and compare them against what you’re currently paying to figure out who’s offering the best deal. To make this process as simple and accurate as possible, we recommend our Merchant Account Cost Analysis Workbook, which includes spreadsheets to help you automatically compare rate quotes.
Lastly, choosing between a third-party processor and a merchant account isn’t entirely a matter of dollars and cents. Sometimes, it’s worth paying a little extra for things like better customer support or more fully featured software. While costs are always going to be important, we recommend that you consider the overall value you receive in choosing a provider. Good luck!