Where do credit card fees come from?
Posted on 10 April, 2007 under Featured, Rates and Fees, Visa and MasterCard by Bryan Johnson
It is known by some, but not all, that businesses pay fees in order to accept credit cards as a form of payment. In fact, over 7 million merchants in the U.S. accept credit cards. During 2006 they collectively paid over 30 billion in fees to offer customers that convenience.
Despite the size of the industry, its a mystery to most as to who is pocketing these billions of dollars in fees and why it has to be so unbelievably complicated. I had a CPA tell me the other day, “I’m a smart guy. I understand numbers, pricing and reconciliation, but for whatever reason I just cannot get my head around credit card processing fees.” He’s not alone. Hopefully this article will clear up some of that confusion as I provide some context about where credit card fees come from, who’s making the money, and how fees and rates are determined.
Banks make roughly 80% of all credit card processing fees
Yes, banks are the biggest benefactors of consumers using plastic. Banks co-issue debit and credit cards with Visa and or MasterCard (AMEX and DISV don’t issue cards through banks). Visa and MasterCard are essentially membership associations owned by the issuing banks, and collectively own about 70% of the market. For example, Visa is a membership association of over 13,000 banks nationwide.
Banks make money every time a card they issued is used to purchase something. For example, let’s assume that a business is paying an effective rate of 3.5% to accept credit cards (that 3.5% is usually comprised of a discount rate and a per transaction fee but I just used a flat rate for simplification purposes). Roughly 80% of that 3.5% is going to the issuing bank. The rest of the 20% is divided among Visa or MasterCard, the credit card processor, and if there is one, the Independent Sales Organization (ISO).
How do banks justify their fees?
Credit card usage has seen explosive growth in the past 20 years for a number of reasons. Consumers get 15 to 45 days to pay original purchases, rewards and other perks, a line of credit for extra spending power, fraud protection, a monthly accounting of all purchases, and plastic is more convenient than cash or check.
All of these conveniences cost banks money. They have costs associated with fraud, bad debt, customer support, rewards and other perks, and float (they pay for your purchases before you pay them). Putting two and two together here on the creation and payment of fees, banks come up with rewards programs but merchants end up picking up their tab!
Continuing our example, if you buy movie tickets for $20 and the movie theater is paying 3.5%, the bank that issued that credit card would make $0.56 ($20 x 3.5% = $0.70, x 80% equals $0.56). Visa and MasterCard add their respective fees of .0925% and .0950% on top of what the banks charge (Note: that’s 9.25 and 9.50 basis points. 100 basis points equals 1%). Adding the fees from the bank and Visa or MasterCard together form what is called ‘interchange’.
You now understand why you find a credit card offer in your mailbox everyday. Outside of the 18% interest rates, annual fees, and late fees, being a card issuer is a lucrative business! Banks are making money on both the front and back end.
That seems simple enough, why does everyone say it’s so complex?
There are over 100 different interchange ‘rates’ or ‘categories’. The particular rate that is charged on any given transaction depends on a number of variables, including:
1) The type of card that is used in the transaction i.e. debit, credit, rewards, or business card, international, etc.
2) Where the card is used i.e. restaurant, retail, gas, business to business, ecommerce, etc.
3) The method of usage i.e. swiped, over the phone, or via ecommerce.
4) What information the business captures during the transaction i.e. name, address, tax ID, tax amount, unit description, etc. (the information required is a whole other layer of complexity).
5) When the transaction is submitted to the processor for settlement and funds transfer after the initial authorization.
As you can see, it’s a very complicated matrix. Very few people, including those who’ve been in the industry for years, really understand interchange.
Qualifying for different rate categories and getting hit with downgrades can be expensive
Merchants can often do more than they think to better manage the credit card fees they pay. For example, transactions can be ‘downgraded’ when they don’t meet interchange requirements. Reasons for downgrades include not capturing the correct information when processing (such as billing address), settling the transaction after a certain period of time, not swiping the transaction and many more. Learning how to recognize these penalties and then making the appropriate adjustments can help you lower your fees.
One example is if an a restaurant employee hand keys your credit card number into the point of sale system because the magnetic strip can’t be read, the transaction falls into a different rate category . The transaction is penalized because ‘non swiped’ transactions carry more risk and therefore higher interchange fees. The increase in rate can be significant ranging from 30 basis points to 1.6%, or more. Actual rates of course vary according to the fee structure you have with your existing provider.
Different rate categories and downgrades are the dirty little secret for merchant service providers. It’s where they make most of their margin because they offer artificially low rates and don’t disclose higher market ups on transactions that don’t fall into a specific rate category. Too many merchants fall for this and think their paying the single, highly competitive rate that was advertised.
A quick search of merchant service providers will demonstrate that non disclosure of fees is a standard practice. See two examples here.
Your undecipherable monthly credit card statement
As icing on the cake, the unreadable format most merchant service providers use to present this information to you on a monthly basis doesn’t help. Of course, the format used is not because they have no other option, it’s because that’s what makes them the most amount of money.
The frustration with credit card fees
Some merchants accept credit cards because they find them to be a easier method of accepting money from customers. Most, however, accept them because they have no other choice and the costs can be significant. Many merchants and advocacy groups have cried foul lately with Visa and MasterCard increasing ‘interchange’ fees over 117% in the past five years while maintaining over 70% market share. The Card Associations have been accused of being monopolistic.
Interchange has come under increased pressure lately
A few years ago, Wal-Mart won a class action lawsuit against Visa and MasterCard. They claimed that interchange was being improperly priced with debit cards having the same interchange rate as credit cards. Among other things, they argued that debit cards should be have a lower interchange rate because money comes directly out of the account versus a credit card where there is 15 to 45 days between purchase and payment. The courts agreed and awarded Wal-Mart and other retailers billions of dollars in compensatory damages. There are currently a number of other legal battles against the Card Associations surrounding interchange.
21 Comments so far
There is huge pressure today on interchange fees, but it is doubtful that interchange will simply go away or get dramatically slashed, which is what merchants are fighting for. All payment brands, not just Visa and MasterCard, compete to get banks to issue cards with their brand, and interchange is one of the most important features that banks look at when choosing a brand. There is increasing pressure on Visa and MasterCard to satisfy merchants much better than in the past. Rather than seeing interchange get slashed, you can expect to see major innovation and new features created by the payment brands for the benefit of merchants, in order to take the pressure off of interchange. The IPO’s of both Visa and MasterCard also push strongly in this direction.
Great Article. Even after being in credit card processing industry for more than 7 years, the article was enlightening.
Thanks Bryan
What I do not think is fair at all is the fact that the credit card companies forbid the stores to pass the cost to the customers who pay with credit card. If a credit card is providing a service to a customer (rewards and time to pay and such) the customer using a credit card should pay for it. If credit card users and noncredit card users are paying the same amount, basically the second is paying for the services given to the first.
I try to pay cash. Banks are rich enough.
As the owner of a small business for the last 6 years I’ve seen firsthand the effects of the tactics of both the banks and processing companies as they’ve gouged a rapidly increasing amount out of my profits. Add to that the natural increase in consumers usage of plastic over other methods and it’s become an instance of the more business I do, the more money just pours through and into the pockets of other companies as both the percentage of each card transaction they take increases, as does the percentage of transactions paid by card.
The harder I work, the more money they make. They can increase their fees nearly endlessly, but my options to recoup those expenses are limited. Increase prices beyond a certain point and I will lose business. Requiring a minimum purchase for cards, not allowed by processors.
Add to all this that the banks and processing companies think they can do whatever they want. Recently, my merchant processing company upgraded their security to help prevent fraud, identity theft, etc. Great, it should be their responsibility to keep their security up to par, right? But how do you think they paid for it? They added a “Data Security Standards Fee” to my most recent statement, a fee that was more than double my total interchange and processing fees for the month. Essentially they took the expense of keeping their security up to date and divided it amongst all the merchants who use them, automatically debiting it from our bank accounts before we even knew what was going on.
I’m still trying to get an answer from them as to where exactly in my contract or schedule of fees they are allowed to assess a random fee as such. So far they’re not saying much. If they can’t show me where I signed to allow such behavior I’m considering passing the info along to a class action lawyer. These companies profit enough on the work of the businesses, passing along their business expenses to us is going too far.
Yes, there are fees assessed for using a credit card. These fees are solely the responsibility of the business but think about it.
Would you prefer checks? Anymore, if anyone under the age of 40(rough estimate, from personal experience, my mom still uses checks, my professional opinion is 60) There is a very large chance of that check bouncing. The bank charges you $20 for the check bouncing the first time. $20 for it bouncing the second time and it being deducted. Then there’s collection fees. Not to mention the fact that once that check bounces once the amount’s put on hold(unavailable) Typically using unavailable funds results in overdraft/unavailable charges. Avg. $35. These fees are acceptable, the bank has to pay someone to process that transaction along the way for you(someone takes the deposit, someone else encodes the check, someone else processes the cash letter the puts the hold, another represents the check and encodes again not to mention the fees assessed by the Federal Reserve for the whole collecting on a check)
Unfortunately, banks cannot just absorb these fees anymore. Have you looked at the yield curve lately? Loans are being priced very close to what deposit rates are paying. More and more income is coming from non-interest income just to keep banks stable.
The world is changing. Change is a fact of life. Read Who Moved My Cheese already. If you refuse to accept credit/debit cards, I’ll personally walk out of your business and go elsewhere. And if your competitor can afford to accept credit cards and you cannot what does that say? They must have reduced costs elsewhere(your take home pay by chance?)
And finally, those businesses charging extra fees or requiring minimums for credit card sales(Sunoco gas stations in particular) I will report you, I have been reporting you, YOU WILL PAY MORE in the long run.
So, Option A, accept only cash and lose my(OUR) business.
Option B, Accept cash and checks and still lose my business and take the risk of all the fees above
Option C. Accept the fact that credit cards may charge you money you see but save you money in the end and increase your gross sales which, increases your profits.
As an ecommerce merchant here’s the part that really gets my blood boiling:
We may more for our unkeyed, online transactions. The standard answer as to “Why?” is that there is a greater risk of fraud.
And fraud does happen. More than anyone would like. But who pays for the fraudelent charges? I do — the merchants do! We get hit twice. Higher rates and loss of income due to fraudelent transactions.
And what can we do about it? Not a damn thing, apparently. Try to report a fishy credit card purchase to the issuing bank and they tell you there’s nothing they can do until the cardmember reports the problem. If they footed the bill they might take the fraud information and pass it along to the police, who could be waiting for the package to be delivered and see who receives it.
It’s not hard to spot the fraudelent transactions. If anyone gave a damn I could have had dozens of people arrested by now. And it’s usually the same people trying over and over again… it wouldn’t take long to drastically reduce the fraud rate.
Err, that should have read “We PAY more for our unkeyed, online transaction.” And I don’t know why I suddenly started misspelling fraudulent. I guess I was so angry I lost my ability to type and spell.
Why does Jc write: “And finally, those businesses charging extra fees or requiring minimums for credit card sales(Sunoco gas stations in particular) I will report you, I have been reporting you, YOU WILL PAY MORE in the long run.” ?
Geeze, Jc, you got a weasel in your trousers or sumptin?
It seems like these fees are a very reasonable way to pass on the costs of cards. Why not reward customers who pay in cash? If you don’t these fees, why not 1) go elsewhere or 2) pay cash?
Why ya gotta be the high school hall monitor, anyway? You must’ve gotten your head stuck in the toilet a lot when you were a kid, Jc.
My companies primary job is to try and get the merchant the “best rate”. It’s alot harder then it sounds and it doesn’t help that visa,mastercard and Amex change the damm rules every year.
I worked for First Horizon Merchant Services, and they used an overly aggressive outside sales team targeting “Mom & Pop” merchants. Likely, few merchants will ever have time to read or understand how they are getting ripped off, especially the merchants that have significant language barriers.
In great numbers, small businesses should give banks the finger by accepting cash only. Instead of visa/mastercard stickers on their doors, they should post an explanation stating they are fighting to bring down the banks.
Let the world know, the term “bank robber” is REDUNDANT.
I used to work for Visa a long time ago in San Mateo. They make a whole lot of money basically sitting around and watching their computers hum. It doesn’t take a lot of people to run the company either, less than you’d think. My source told me as of 1990, they were worth 40 BILLION. Of course it’s a lot more today.
Ripped off by credit card fees?…
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It makes sense, especially for small independent businesses to set minimums for card purchases. They clearly don’t have the sales volume to support these fees. For example, I work at a bakery where people pay for a $0.95 bagel on a card. The profit margin for these individual bagels isn’t very high at all, especially considering packaging and spread included with it. When you add on top of these the card fees, we would barely break even if we didn’t take cash. Also, there is a small independent thrift shop in my town which has a $5 minimum for card purchases. In a store where a shirt is around $1, they have a lot of labor to pay for sorting and processing donations for small profits, and again, the fees put them right on the edge. I completely agree that it is acceptable to take only cash or add a surcharge for credit customers. It’s their business, their decision. No corporation or government should mandate what form they accept payment in.
The money spent processing credit cards is minimal at best and should be looked at as a necessary business expense. You will find that on average, it costs a few cents or a small percentage for each credit card transaction.Nice posting, so informative .Thanks
In response to Nick’s posting on Jan 10, 2008, you are right on the money. I encourage all of my business clients with small average tickets to set a minimum. Yes, I realize that it is against Visa/MC regulations, but as Nick so accurately put it, it’s the merchant’s business, thus, their decision. If Visa/MC doesn’t like it, too bad. Perhaps the merchant will elect to not accept electronic card transactions, and Visa/MC will not make a dime off their business.
In response to Mark’s posting on April 21, 2008, spoken like a true salesperson in the credit card processing industry. And it costs more than a few cents, Mark. And the smaller the ticket size, the more the fees hurt the merchant. And very few business owners are happy with the fees they’re being charged. Regulation of these fees is long overdue here in the U.S.
Whew…. Finally finished reading all of Bryan’s blogs. Very informative. Some interesting, some depressing, and some exciting information here. Both in the posts and in the comments.
My business is going to be selling software as a service (SAAS) so I will be using the systems being discussed here to collect payment for my services and I will be selling applications that will use these systems to do the same for my customers.
I’ll definitely be recommending the reading of this blog and comments to those kinds of customers.
Have a question. Live in an apartment complex in NE part of GA. If you want to pay by credit card you have to pay the processing fee. A very hefty fee at that. I can’t believe they are doing this. I thought all companies have to pay the fee not the consumer excluding gas, electric companies. Please help me with this as it has become a situation with many people and the economy being so bad people have no choice but to pay with cc.
@ Janice - The card associations do allow merchants to charge a ‘convenience fee’ to customers but it must meet certain criteria so as to not discourage or penalize consumers for choosing to use their credit card. For example, the convenience fee must apply to all payment types, e.g. check, credit card, etc. The fee must also be the same for all payment types.
why all the debit and credit cards have the symbol of either VISA or MASTERO…… i want to know about VISA AND MASTERO…. what is the need of these two. please any one give me a Solution ..please
I just stumbled on this forum and found it very informative. Can anyone out there answer my question? Why do transactions paid for with rewards cards get classified as Non-qualified? Everybody use rewards cards now and I fail to see why the merchant should be penalized for the choice of card made by the consumer. I work for a nonprofit and virtually all of our transactions, even though processed online and Verisign secured (AVS and CVC included), are coming through as Non-qual. Any ideas what I can do about this? Accepting credit cards is important for our cash flow.
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