Payment Processing 101: Everything You Need To Know To Get Your Business Up & Running
Running your own business always works much better when your customers actually pay you for the products and services you provide for them. Paying for purchases has become a lot more complicated in the modern world than it used to be. It wasn’t all that long ago that cash and paper checks were the preferred payment methods. Today, however, these methods have faded in popularity as consumers increasingly prefer to use credit or debit cards. Online payments, while commonplace today, have only been available for a little over twenty years. The recent introduction of NFC-based payments, which allow a consumer to make a payment with their smartphone (or smartwatch), adds yet another way for your customers to complete a purchase. Interest in contactless NFC-based payment methods has surged within the last year due to the ongoing COVID-19 pandemic.
Each of these payment methods requires specific hardware (and, in some cases, software) that you’ll need if you want to support them. The days of just having a cash drawer in your shop are long gone. In this article, we’ll review the various payment methods you’ll want to be able to accept as well as explain how those payment methods are processed so that you can receive your money.
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How Does Payment Processing Work?
Customers have a lot more options for paying for purchases today than they did just a few years ago. While cash is still the simplest payment method, it’s fallen out of favor as the use of credit and debit cards has risen. Merchants, of course, prefer to be paid in cash because they don’t need a merchant account to process these transactions, and they receive 100% of the sale price immediately. Paper checks are almost as good, although they require a trip to the bank, and there is a significant risk of fraud or having the check “bounce” due to insufficient funds. While some customers prefer to pay in cash or by paper check, they’re a dwindling minority. Most customers today will want to use a credit or debit card, which requires a merchant account and a payment processor to ensure you receive your payment.
For our purposes, “payment processing” is a series of steps required to authenticate and approve a transaction, followed by an additional set of steps that transfer funds from the transaction to the merchant and the various parties responsible for processing the transaction. We’ll discuss the sequence of events in more detail below. For now, it’s just important to understand that any transaction that doesn’t involve physical currency or paper checks will need to be processed. This includes transactions using credit or debit cards, electronic check (echeck) payments, and online transactions using one of these payment methods.
What Is A Payment Processor?
A payment processor is a business entity that coordinates non-cash transactions by authenticating payment information and disbursing funds from the transaction to the merchant after the sale is complete. Processors ensure that all of the parties to the transaction, including the issuing bank and the credit card association, receive their portion of the funds from the transaction.
Payment processors have set up processing networks that facilitate the flow of information between all the parties to a transaction. While this process was originally designed to operate on a landline telephone network, today’s processing networks mainly use the internet to transmit, receive, and store transaction information. However, landline or cellular telephone networks can still be used for mobile processing or as a backup when a merchant’s internet connection isn’t available.
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.
It’s important to understand that the term payment gateway can 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. Payment gateways — in this narrower sense of the term — are absolutely necessary for eCommerce, as they allow a customer to place an online order from any location. However, as merchant services providers increasingly move to integrated, internet-based payment systems that work in both online and traditional retail settings, brick-and-mortar businesses are increasingly using payment gateways. Cloud-based data storage allows you to access analytical data on your transactions that wouldn’t otherwise be easily available.
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. For this article, however, we’ll refer to a payment processor as being the business entity that processes your transactions. Note that 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.
In this article, we’ll use the term payment gateway solely to refer to the software needed to facilitate online transactions where neither the customer nor the customer’s payment card is physically present.
Methods Of Payment Processing
Before you can accept any form of non-cash payment from your customers, you’ll need to have access to a payment processor that can coordinate among the various parties to this type of transaction and see to it that you receive your funds. We use the term merchant services provider to refer to any entity that can perform this function, regardless of whether they offer unique merchant accounts to each business or aggregate the accounts of all merchants using their services.
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 the two:
- Merchant account providers offer a traditional, full-service merchant 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. Examples include Dharma Merchant Services and Helcim.
- 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, 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.
Note that you will also need a merchant services provider to process echeck or ACH payments. This function usually requires a separate service as part of your account, but processing costs are very low.
In addition to paying processing rates for each transaction, maintaining a merchant account also usually requires the payment of a variety of account fees. These fees are different for every processor, and sometimes even among merchants using the same processor. For a more in-depth discussion of merchant account fees, please see our article, The Complete Guide To Merchant Account & Credit Card Processing Fees.
Credit Card Processing
While credit cards have been around for over 100 years, their use has skyrocketed within the past few decades. Although this has led to a nationwide crisis in consumer credit card debt, it’s also created headaches for merchants who have to set up a merchant account and pay for processing costs. Nonetheless, credit card use has become so prevalent that, for most merchants, the additional sales more than make up for the cost of maintaining a merchant account.
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 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. This 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.
The advent of interconnected banking and credit card processing networks has drastically sped up the process of purchasing with a credit card. While the transaction approval process is rather complicated, it can be completed within just a few seconds in most cases. Here’s a very simplified explanation: The consumer’s credit card data is submitted to the processing network, which contacts the issuing bank to ensure that sufficient credit is available on the consumer’s account to cover the cost of the purchase. Several anti-fraud checks are also completed, and if no red flags are raised, the transaction is approved. The payment processor then processes the transaction, paying the interchange to the issuing bank and credit card associations, and keeping the remainder of the processing charge. Only then are funds released to the business owner’s merchant account. Unfortunately, this part of the process takes much longer, as most merchants submit their transactions in a batch at the end of the day. It can take up to several days before funds are deposited into your account.
Debit Card Processing
Paying with a debit card is also increasingly popular with consumers, particularly for small, day-to-day purchases (such as groceries and automobile fuel). These transactions are also 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 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 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.
ACH & Localized Payment Methods
While credit and debit cards continue to be the most common forms of non-cash payments, there are other payment methods available to customers that will require the services of a payment processor to ensure that you get your funds. 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, which can be either entirely digital or involve the scanning of a paper check for processing, are also very common.
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.
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.
eCheck processing services eliminate all these problems, but they’re not free. 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 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.
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.
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. See our article, How To Accept Bitcoin, for more details.
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 services 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 Approach Payment Processing?
With so many payment methods to choose from, you’ll have to decide which ones are important to your business. While there are still a handful of cash-only businesses out there, today, most retail merchants accept credit and debit cards due to the increased sales generated by offering this payment option. 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 (such as Square or PayPal). Larger businesses will require a full-service merchant account due to the 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.