Payment processors help your small business accept credit card transactions, but how to do they work? Find out in this guide.
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How does payment processing work? Payment processing is the series of digital communications between banks, processing networks, and POS systems that make it possible for your business to accept non-cash payments.
In short, if you want to accept payments via credit cards, virtual wallets, and more, you’ll need to implement payment processing. If you’re not sure where to start, we’ve got you covered.
This guide takes a deep dive into how payment processing works, what it takes to process payments, and how to choose a payment processor, so you can choose the best credit card payment processing company for your small business.
Let’s dive in.
What Is Payment Processing?
Payment processing is a series of steps that facilitates communication between banks that includes authentication, transaction validation, funding, and fund settlement — it’s how businesses get paid when customers don’t use physical cash.
Payment processing allows businesses to accept payments via credit card, debit card, check, digital wallet, cryptocurrency, and more. While payment processing starts at your business’s point-of-sale system, funding and settlement (ie. when the money reaches your business’s bank account) can take up to three days.
How Does Payment Processing Work?
Payment processing is the approval and settlement of a transaction where a customer makes a non-cash payment, and your business receives the payment directly to its bank account. Here’s a step-by-step breakdown of how payment processing works.
- Payment is initiated via customer. Your customer pays via one of your business’s accepted payment methods.
- Payment information is validated for approval. Depending on the payment method, information like the card number, security code, expiry date, cardholder name, and more is received by a payment gateway and sent to a payment processor.
- The payment processor verifies the card’s security. This step in the payment process is just to ensure that the transaction taking place isn’t fraudulent.
- Your payment processor communicates authorized transactions. Depending on the payments used, payment processors communicate information about approved transactions to the source (eg. payment card networks like Visa or AMEX).
- Funds are debited from customer accounts. Once the transaction has been approved and validated, it moves into the settlement and funding phase, where money is debited from the customer’s account.
- Your business bank account is funded. The debited funds are transferred to your business bank account (ie. a merchant account).
What Is A Payment Processor?
A payment processor is a vendor that facilitates electronic payments by acting as the messenger between banks and merchants. The payment processor authenticates payment information and disburses funds to the merchant after a sale is complete.
When it comes to payment processing as a whole, payment processors are the companies that earn money by charging a fee for processing payments, regardless of the transaction’s outcome. In the US, some of the most popular payment processors include Helcim, Clover, Square, and Stripe.
What Is A Point-Of-Sale System?
A point of sale system, also known as a POS system, is a type of hardware or software that is used to facilitate payment processing. When accepting payments, your POS is where the transaction starts, whether it’s a customer walking up to the cash register to pay or checking out online.
What Is A Payment Gateway?
A payment gateway is a processing network that communicates over the internet to send and receive payment information between merchants, issuing banks, credit card associations, and other parties to a transaction. Payment gateways approve purchases, attempt to detect fraud, and help ensure that you receive your funds from a transaction.
The term payment gateway may also refer to a software-based service that allows merchants to process transactions solely over the internet, without physical access to the customer’s payment card. These cloud-based payment gateways are necessary for eCommerce, but are increasingly being used in brick-and-mortar businesses.
Payment Processor VS Payment Gateway
The terms payment processor and payment gateway sometimes get used interchangeably, and they can both be used to refer to the same thing — a payment processing network that confirms the validity of a transaction and transfers funds from that transaction to all the involved parties. Here, we use the term payment processor to refer to a business entity that processes your transactions.
Full-service payment processing requires tremendous resources and capital, so there are only a handful of companies that function as direct processors. Most merchant services providers, including payment service providers (PSPs) such as Square, contract with one of these large, direct processors to handle transaction processing.
What Is A Merchant Service Provider?
A merchant service provider is any entity that can coordinate non-cash payment processing for your business. Some merchant service providers combine payment processing and merchant account services, so merchant services providers can be further broken down into two categories: merchant account providers (MAPs) and payment service providers (PSPs).
Here’s the difference between merchant account providers and payment service providers:
Merchant Account Providers
Merchant account providers offer a traditional, full-service merchant account (business bank account) with a unique identification number that identifies the business to all parties involved in processing a transaction.
Merchant accounts are very stable but can be quite expensive for a small business. In addition to paying processing rates for each transaction, maintaining a merchant account also usually requires the payment of a variety of merchant account fees.
To process echeck or ACH payments, you’ll need a merchant services provider. This function usually requires a separate service as part of your account, but processing costs are very low.
Examples include Dharma Merchant Services and Helcim.
Payment Service Providers
Payment service providers offer aggregated accounts where every merchant using the service shares the same merchant account. You won’t have a unique merchant account ID number when using a payment service provider, so accounts aren’t as stable as a true merchant account. However, overall costs are significantly lower for a small or newly established business.
Examples include Square, PayPal, and Stripe Payments.
How To Choose A Payment Processor For Your Business
When choosing a payment processor for your business, it’s essential to consider which payment methods you want to accept for your business. Depending on the payment method you choose to accept, you’ll have different costs and hardware requirements.
Here’s how the payment methods you choose to accept for your business will impact payment processor pricing and hardware needed.
Credit Card Processing
While banks issue most credit cards, they’re also sponsored by a small number of credit card associations, such as Visa, Mastercard, Discover, and American Express. These entities charge a variety of fees whenever a purchase is made with one of their cards. These credit card processing fees are collectively known as interchange.
When a transaction is processed, the processor will charge you both interchange and markup in exchange for its processing service. Unfortunately, interchange rates vary widely based on the type of card used and other factors. This has made it easier for processors to rake in higher profits by offering merchants “simplified” processing rate plans (such as flat-rate or tiered pricing).
For this reason, we recommend interchange-plus pricing for most established businesses. The interchange-plus pricing method adds a fixed markup to each sale, regardless of the transaction type.
For example: interchange + 0.30% + $0.15 per transaction. While the interchange fee will vary widely with each transaction, the markup that you pay to your processor will always be the same.
Debit Card Processing
Debit card transactions are much easier to process, as the issuing bank doesn’t have to decide whether to issue a credit to the consumer to cover the cost of the purchase. As long as there are sufficient funds in the consumer’s bank account, the transaction will usually be approved.
Because there is no need to issue a credit, the overall risk associated with debit card use is significantly lower than it is with credit cards. For this reason, the interchange rates for debit card use are substantially lower as well.
One of the reasons we encourage you to avoid tiered credit card pricing plans is that many of the processors that offer these plans charge the same rates for debit card use as they do for credit cards. This practice can result in you paying significantly more for debit card processing than you should. This is also a shortcoming with flat-rate credit card processing pricing plans offered by providers such as Square. However, the lack of account fees usually associated with these types of processors often outweighs this consideration, especially for small or seasonal businesses.
If you plan to accept debit card transactions and want to ensure that you pay the lowest possible rates, it’s important that you add a PIN pad to your countertop terminal setup. PIN pads allow your customers to authenticate their debit cards using their Personal Identification Number (PIN). This method is much more secure than simply collecting a signature from a customer, and you’ll pay the lowest processing rates available.
Without a PIN pad, your debit card transactions will process as credit cards, and the much higher credit card processing rates will apply.
eChecks & Localized Payment Methods
In the United States, ACH (Automated Clearing House) payments that generate an all-digital payment from the customer’s checking account are very popular, particularly in the eCommerce sector. eChecks, are the digital counterparts to paper checks and are typically processed much more quickly than paper checks.
eCheck and ACH payments go through a separate processing method than credit/debit cards. While it’s possible to have an echeck-only service without the need for a merchant account, this arrangement won’t be practical for most businesses. eCheck processing is usually offered as an optional service (at additional cost) due to the decreasing use of paper checks by consumers.
Because not all merchants need them, most merchant services providers offer echeck processing as an optional service and charge a monthly fee for it (usually $20-$30). You’ll also have to pay a small transaction fee for each processed check, but it’s much less than most credit or debit card transactions.
If your business has a lot of overseas customers, you might also need to include localized payment methods that are popular in places outside the US. For example, AliPay and UnionPay are popular payment methods in China. You’ll want to do your research very carefully in finding a provider that can support these payment methods, as they often don’t advertise their availability very prominently.
Although it’s becoming less common, some consumers still prefer to pay by check whenever possible. Merchants can accept paper checks without the need for an echeck processing service, and you’ll receive 100% of the sale price. However, you’ll have to make a trip to the bank to cash the check, and it might be rejected due to insufficient funds. There’s also the possibility of losing a paper check.
If you want to accept paper checks, you’ll also need a check scanner, which scans an electronic copy of the check and submits it to the customer’s bank to confirm the availability of funds. As long as the check won’t bounce, the transaction is approved immediately. Because of the monthly fees associated with most echeck processing services, we recommend them only to businesses that accept a high volume of paper checks from their customers.
Digital Mobile Wallets
We’re using the term “digital wallet” here to include payment methods that rely on near-field communication (NFC) technology. NFC-based payment methods utilize small, very short-range radios in both the consumer’s payment device (typically a smartphone or smartwatch) and the merchant’s credit card terminal.
Apple Pay and Google Pay are currently the most popular forms of NFC-based payments. This technology has only been on the market for a few years, and acceptance has been slow. The use of this payment method is growing, however, and merchants should consider adding it to meet the increasing demand.
NFC payment methods are, of course, ultimately tied to the user’s credit or debit card, and these transactions are processed as a regular card transaction without any additional fees or markup. While they’re generally not available to independent merchants, other forms of digital wallet payments, such as Walmart’s proprietary Walmart Pay, use the smartphone’s camera and a QR code scanner to accept payments.
While NFC-based payment methods have been around for several years now, their popularity has soared during the ongoing COVID-19 pandemic due to the need for a “contactless” payment method. US-based issuing banks are now also beginning to roll out credit cards with NFC chips embedded in them, allowing the customer to wave their card over the payment terminal without having to swipe or dip it.
While the majority of small businesses do not accept Bitcoin or any other form of digital currency, you might want to consider adding this payment option at some point. Merchant services providers usually go through a third-party processor to offer Bitcoin processing.
While not a payment method per se, gift cards reward customer loyalty and encourage repeat purchases. Gift cards are quite popular with consumers, and almost all merchant service providers in the industry can set you up with a gift card program as part of your merchant account.
What’s The Best Way To Process Payments?
With so many payment methods and payment processors to choose from, you’ll have to decide which ones are the best fit for your business. Whether you need a full-service merchant account or a payment service provider (PSP) will depend on the size and nature of your business.
Merchants operating seasonally or processing only a few thousand dollars per month can usually save money by signing up with a PSP. Larger businesses will require a full-service merchant account due to lower processing costs and increased account security.
For a brief overview of our highest-rated merchant services providers, check out our merchant account comparison chart.
Payment Processing FAQs
How much does payment processing cost?
The average credit card payment processing fees range from 1.5%-3.1% of each transaction. Payment processing costs depend on the payment processing vendor your business uses, the payment methods your business accepts, and the pricing structure your payment processor uses.
What does processing payment mean?
Processing payment means that a transaction is being completed via a payment processor. Payment processing includes ensuring that a transaction is being handled securely and that funds are moved only after all payment information has been validated.
What are the payment processing stages?
The three stages of payment processing include authorization, funding, and settlement. The authorization stage validates the security of the transaction and verifies its approval. The funding and settlement stages are concerned with the movement of funds from the customer’s bank account to the merchant’s bank account.
What do payment processors do?
Payment processors act as the intermediary between banks and merchants when handling non-cash payments. Payment processors communicate with both entities in the transaction to provide vital payment information. Payment processors collect a fee for each payment processed.
What are the best payment processors?
The best payment processors include Stripe, Square, Helcim, PaymentCloud, Dharma Merchant Services, and more.