What Is Credit Card Processing and How Does It Work?

The process by which a business collects payment from a credit card transaction involves two steps, authorization and settlement, and three key players: customer, issuing bank and merchant.
Karrin Sehmbi
Lisa Anthony
By Lisa Anthony and  Karrin Sehmbi 
Updated
Edited by Sally Lauckner

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Using credit cards for purchases is a convenience many consumers have come to expect, but not many customers or business owners actually know how credit card processing works. The process is complicated, involving industry lingo that may be unfamiliar to some, the coordination of multiple participants and the acquisition of a card-reading device.

Much of the process happens behind the scenes, however. And while it’s useful to understand the entire process and the key players in it, many business owners will find that the most important aspects to understand are the hardware and software needed for credit card processing and the fees involved.

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What is credit card processing?

Several moving parts are involved in processing a credit card transaction. On one side of the transaction, you have the customer and the bank that issued their credit card. On the other side, you have the merchant and the bank that will receive the payment. Details about the transaction travel between the two banks through a credit card network, and the payment processor helps make sure things run smoothly.

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Key participants in credit card processing

A good first step in understanding the process is to review industry terms for the key participants:

  • Cardholder. A cardholder is the customer, or consumer, who is using the card for payment. The cardholder could be either the owner of the card or an authorized user.

  • Issuing bank. An issuing bank is the entity that issued the credit card to the cardholder and is responsible for authorizing the transaction. If a transaction is approved, the issuing bank sends funds to the merchant bank, which in turn bills the card owner through a monthly credit card statement.

  • Merchant. A merchant is a business that accepts credit card payments from customers for its goods or services. These include in-person, online or phone payments.

  • Merchant bank. A merchant bank, also known as an acquiring bank, maintains the merchant account where the funds from credit card transactions are deposited. Some merchant banks act as payment processors in the card transaction. Others rely on third-party payment processors to manage the payment details.

  • Payment processors. A payment processor, or merchant services company, helps manage the transaction process with the merchants, banks and card networks. In addition to helping authorize transactions and ensuring the transfer of funds, some payment processors also offer the hardware and software required to accept card transactions.

  • Card networks. Credit card networks such as Visa, Mastercard, American Express and Discover are responsible for the infrastructure that allows the transmission of credit card details between the merchant bank and the issuing bank. Credit card networks have rules for the use of their networks and set interchange fees for their services.

How does credit card processing work?

Credit card processing happens in two steps: authorization and settlement. Although the authorization step — when a card is approved or declined — generally takes only a few seconds, the settlement stage is just as important to the merchant receiving its money.

Authorization

The cardholder starts the process by providing their card information through the merchant’s card-reading device. The card information is then sent to the merchant bank or the payment processor, which, in turn, routes the information through the appropriate card network to the issuing bank. After the issuing bank confirms the card details and checks the cardholder’s account status and available credit, it sends an approval or denial to the merchant bank. The merchant bank or payment processor then forwards the decision to the merchant’s card reader.

The authorization process for online and e-commerce card transactions may be slightly different and could require a payment gateway in addition to a payment processor.

Settlement

In the settlement process, funds are moved from the issuing bank to the merchant account. Generally, merchants send batches of authorized credit card transactions to their merchant bank or payment processor at the close of business or another scheduled time. These transactions are routed to the card networks, which work with the issuing banks and merchant banks to ensure funds are deposited into the appropriate merchant account.

The issuing bank deducts interchange fees from the transaction amounts before transferring the funds to the merchant account. As a general rule, it takes one to three business days for the settlement process to be completed.

What’s needed to process credit cards?

A merchant will typically need hardware and software to capture the information needed to process a credit card transaction.

Hardware

The hardware for credit card transactions can be as simple as a compact card reader that plugs into a smartphone, or it can be a device with more features, such as a terminal, register or an entire point-of-sale, or POS, system. These devices collect and then transmit card data through the internet or a phone line to the merchant’s payment processor. Payment processors typically offer a variety of options when it comes to hardware.

Software

A payment app is generally needed for credit card processing. Some are free with the purchase of hardware, and others may require a monthly fee. These software programs can include features such as inventory management, customer tracking, the ability to send email receipts, and reporting and analytics.

How much are credit card processing fees?

In addition to the costs associated with the hardware and software, a merchant will also pay credit card processing fees. In general, total fees range from 1.5% to 3.5% of the transaction amount and involve three separate fees:

  • Interchange fees: Interchange rates are set by the card networks, and fees are paid to the issuing bank. They're typically the largest portion of the processing fees.

  • Assessment fees: These fees are paid to the card networks.

  • Payment processor fee: This fee goes to the payment processor, which may be the merchant bank or a third-party processor.

Merchants can pay additional fees based on the payment processor they use and the services provided. For example, some payment processors charge a fee for PCI compliance, while others don’t.

Learn More About Credit Card Processing Fees

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