Payment Processing 101: How Credit Card Processing Works

Before I interviewed with our payment technology company, I have to admit that I had no idea that credit card processing and payment tech companies existed that specialize in working with merchants to accept credit cards for their business. I always thought when businesses needed a credit card processor they would go straight to their bank. While banks are great for so many things, they are not payment processing experts as a company like ours is. Read on to learn exactly what payment processors are and how credit card processing works.

fd 130 payment processing terminal, credit card machine

What Are Payment Processors?

In short, a payment processor is a company that is responsible for managing all kinds of payment transactions except cash, but do supply the technology for merchants to manage their own cash transactions. These transactions include: credit cards, debit cards, ACH payments, and gift card payments. They work with the card brands (Visa, Mastercard, Discover, and AMEX) to supply and authorize settlement services to merchants’ banks so that the merchants can receive their money.

Payment processors are experts in the industry, working heavily with:

  • Large, medium, and small business credit card processing
  • Payments security
  • PCI compliance managers to ensure merchants are PCI compliant
  • Payment platforms
  • Virtual terminals
  • Electronic checks
  • Touch payments
  • EMV
  • Credit cards with RFID chip
  • Mobile credit card processing
  • Payments by ACH
  • And much more

[Download our free checklist: What to Look for in a Payment Processor]

How Credit Card Processing Works: Key Players

Each time a credit or debit card is used there are several processes that must be accomplished to complete the transaction. These processes involve each key player.

The Associations

Mastercard and VISA are publicly traded organizations whose board is composed of member financial institutions. They provide the branding and network to the issuing banks.

Mastercard and VISA set and enforce rules and regulations governing their bankcard, such as operational procedures, interchange rates and qualification requirements, and the base networks through which all transactions are approved and settled. They create advertising and promotional programs to support their brands and develop new products to serve banks and consumers.

The Issuing Bank

The issuing bank provides the card to the consumer (cardholder).  An issuing bank is a licensed member of Mastercard and/or VISA and can also be an acquirer. An acquirer is a financial institution that processes credit or debit cards on behalf of the merchant.

The issuing bank solicits, screens, and approves the cardholder for a specified credit limit. When the cardholder uses the card, the issuing bank approves or declines the sale, bills the cardholder for charges made to the card, and collects the payments from the cardholder each month.

The Cardholder

The cardholder uses the credit card given by the issuing bank to purchase goods and services or to obtain cash advances. The cardholder is expected to sign the back of the card and limit its use to only authorized users, stay within the assigned credit limit, and pay the issuing bank all or a minimum amount of the balance by the due date indicated on each monthly statement.

The Merchant

The merchant provides goods and/or services to consumers and businesses. Mastercard and VISA require that the merchant be financially responsible and of good repute and adhere to all rules and regulations set forth by the Associations in regard to accepting their cards. 

Priority Payments Local requires the merchant adhere to the Merchant Processing Agreement (contract) signed with Priority.  The merchant is required to complete a Merchant Application providing information about the ownership, type of business, and method of conducting business.  The merchant will also be provided with documents that detail the rates and fees to be paid in conjunction with the merchant account.

The Sales Agent

The sales agent (who works on a direct sales or ISO model) is the person who originally presents the agreement and pricing to the merchant. The sales agent may also sell or lease/rent payment technology such as credit card processing machines to the merchant. Merchant accounts may be sold by employees of the member bank, a registered agent bank, a registered ISO (Independent Sales Organization), or an MSP (Member Service Provider) working for any of these above. The sales agent must always present him/herself to the merchant showing the relationship to the member bank and not as an employee of Mastercard, VISA or the Member bank.

[Download our free checklist: What to Look for in a Payment Processor]

The Processor or Acquirer

In order to facilitate the transactions between the merchant and the cardholder, a processor or acquirer is required. The processor may also be referred to as the back-end processor or merchant accounting system. They provide a payment link between all the parties involved in the transaction process. Many processors or acquirers also provide back-office functions such as:

  • Customer Service
  • Chargeback support
  • Risk management and security of card data
  • Terminal or PC Software to be used at the Point of Sale (POS)

The Member Bank

Mastercard and VISA require that the financial institution behind the merchant accounts be a primary member of each association. The payment of transactions to the merchant must originate from the member bank. The member bank also acts as the sponsor bank to any agent bank or ISO/MSP relationships.

While all the parties mentioned above are required in the transaction process there are other parties that may be involved. These may include the following:

An Independent Sales Organization (ISO)/Member Service Provider (MSP). Mastercard, Visa, and many banks have realized that allowing third parties to sell and/or provide different services will increase the exposure of their product. ISO is the term used by Visa and MSP is the term used by Mastercard. They are, in essence, the same thing but must be registered with each association through a Sponsor Bank. 

The Front-End Network (Platform). This is the network that carries the transaction to and from the point of sale systems (POS systems). The front-end network, or front-end platform, will “auth and capture” the transaction data.  First Data owns several platforms that we utilize:

  • Omaha
  • Nashville
  • North (Cardnet)
  • Atlanta (BuyPass)

The Back End. This is the processor that submits all the transactions through to the various card associations, prepares the payment to the merchant, and prepares monthly billing statements for the merchants.

The Voice Authorization Center. Each front-end network will provide an 800 number service for the merchant to call if POS system is not functioning or the response to call for voice authorization is given.

The Depository Bank. Each merchant must have a checking account or demand deposit account (DDA) to receive electronic credits and debits for deposits and fees. 

How Does Credit Card Processing Work? Diagram & Details

Each time a credit or debit card is used there are several transaction processes that must be accomplished to complete the transaction. These processes involve each of the players that were previously described.  The three processes are authorization, settlement, and billing. 

The authorization is the permission of the issuing bank to accept a card for payment. Obtaining the authorization on a card does not guarantee payment or that a chargeback may not be initiated at some later point.

how credit card processing works diagram

Step 1

The transaction begins when the cardholder purchases goods or services using a credit card. The merchant must obtain an approval code from the issuing bank that acknowledges that the card is a valid card and the amount of funds requested are available from the cardholder’s line of credit. The transaction can be done as a card-present or card not present transaction.

Step 2

The POS terminal sends the transaction information through the front-end network to a host computer that will verify the merchant identification number (MID), determine from the card number what type of card, and route the message so that it gets to the correct card association, i.e. MasterCard, Visa, Discover, etc. 

Step 3

Once connected with the correct association, the transaction is routed to the proper issuing bank or their designated stand-in processor for the authorization. The issuer determines whether the credit card transaction can be approved or declined.  The issuer will send back one of the following responses:

  • Approval Code. This response indicates that the card is valid and has enough funds available to complete the sale.  The approval code is recorded on the sales draft. An approval code is not a guarantee of payment.
  • Decline. This response indicates that the issuer will not approve the transaction. There could be many reasons for a decline such as the charge may exceed the credit limit or payments are past due on the card, but the reason is not displayed or known to the merchant. The merchant should ask the cardholder for another form of payment.  The cardholder should be instructed to contact their bank for specific information regarding the account.
  • Pick Up Card. This response is given when the issuer wants the card returned for some reason. The merchant is not required to retain the card – it should only be kept if it can be done so safely.  The cardholder should be instructed to contact their bank for specific information regarding the account. If the merchant does keep the card there is generally a reward.  The card should be cut lengthwise across the magnetic stripe and sent to the security department of their processor. 
  • Referral or Call Auth Center. This response indicates that communication other than just an electronic approval is required.  The merchant should call the number given by the processor for voice authorizations. The operator may ask for additional information regarding the transaction or the cardholder. An approval code or decline will be given by the operator.  If the transaction is approved, it will need to be re-keyed into the POS terminal to be included with the batch.

Step 4

When the transaction with the issuer response is passed back through the association, a “snapshot” of that transaction is taken. This is important for the purpose of qualifying the transaction later for the proper Interchange category, which in turn affects the merchant’s discount rate and fees paid on that transaction. The association routes the transaction back to the front-end network that may also store the transaction data to be used during the settlement process.

Step 5

The front-end network returns the transaction, including the response code and a reference number, to the merchant’s POS terminal.  If the merchant has an electronic printer, a receipt will print with all the transaction data and a place for the cardholder’s signature. If a manual imprinter is used, the approval code should be included on the sales draft. In a card not present environment, a transaction receipt or sales draft may not be produced but, all the transaction data must be retained by the merchant.

Obtaining the authorization on a card does not guarantee payment or that a chargeback may not be initiated at some later point. This entire process usually takes less than 10 seconds, depending on the front-end network and POS terminal used by the merchant. In order for the merchant to receive payment on these transactions, he/she must now “settle the batch” or “batch out.”

What to Look for in a Payment Processor: Checklist

Now that you know how credit card processing works, it’s time to choose the best processor for your business. Download our free checklist on what to look for in a payment processor.

Marisa Sanfilippo
Marisa Sanfilippo
Director of Marketing and Strategy, Priority Payments Local

Leave a Reply

Your email address will not be published. Required fields are marked *