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Credit Card Merchant Services: The Essential Guide

A customer handing a credit card to the merchant for credit card processing

New entrepreneurs are often caught off guard by the realities of running a small business. They might discover that certain aspects of their day-to-day operations are much more complicated than they initially thought. Perhaps the best example is merchant services, or the way businesses accept and process different payment methods.

To your customer, this seems as simple as swiping a credit card or pressing a few buttons. They don’t see any additional deductions or approvals taking place. The truth is that every debit or credit transaction results in a multitude of smaller transactions that affect several financial institutions. Only after these transactions are completed does the business get paid for the sale.

What makes merchant services even more confusing is the lack of a single, precise definition. The term was initially created to describe the services required for accepting credit card payments. Today, “merchant services” can refer to any tool or company involved in the processing of card-based payment methods. Someone looking for merchant services could be looking for a new company to work with, new hardware to use, or an entirely new processing system.

This guide will go over how merchant services work, the companies that provide them, and their pricing structures. This will ultimately help you determine which types of merchant services make the most sense for businesses like yours.

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    What Are Merchant Services?

    Generally speaking, merchant services refer to the services and technology involved in the accepting and processing debit and credit card transactions. To understand how merchant services work, business owners must first learn what goes on behind the scenes whenever they make a debit or credit card payment.

    How Do Merchant Services Work?

    The merchant services process begins when a customer swipes, inserts, or taps a debit or credit card. You or your customer may then have to enter information into a card processing terminal. The hardware and software used for swiping and inserting come from a merchant service provider, or “payment processor.”

    The following steps usually transpire in a matter of seconds.

    First, the payment processor checks with the customer’s bank, approving, or denying the payment. If the bank approves the payment, the payment processor takes a fee and deposits the remainder into your merchant account. This is the separate bank account you’ll have to set up to accept debit and credit card payments.

    Merchant Services Products

    As you can see, the merchant services process’s first step involves the products sold by payment processors. These software or hardware pieces allow you to accept different forms of payments, i.e., online and in-person.

    Here are the tools you’ll need to accept these payment methods:

    1. Payment Gateways

    Businesses that wish to accept online payments must use payment gateways. This is a piece of software sold by payment processors that mainly takes a credit card terminal.

    2. Credit Card Terminals

    To accept in-person payments, you’ll need a piece of hardware for swiping, inserting, or tapping debit and credit cards. Credit card terminals are directly connected to your payment processor, and they come in numerous shapes and sizes.

    3. Point of Sale Systems

    Point of sale (POS) systems like PayPal and Square involve both hardware and software. These payment processors provide equipment for accepting payments and software for managing day-to-day sales, tips, commissions, etc. You can even use point of sale systems to accept gift cards, set up loyalty programs, and track inventory.

    Since the point of sale systems do the same things as traditional payment processors, the term “point of sale system” and “merchant services” are often used interchangeably. You could say that the term “point of sale” was created solely to differentiate companies like PayPal and Square from traditional payment processors.

    Merchant Service Providers

    Now that we’ve established the tools you’ll need to accept debit and credit card payments, let’s move on to the companies that sell these tools, a.k.a. Payment processors. You cannot accept debit and credit card payments without the hardware and software sold by payment processors. Much like small business loans, the right payment processor for your business depends on various factors, like your industry, your most common payment method, and the size of your business.

    Most payment processors can be categorized as either merchant account providers or payment service providers.  Here are the definitions and primary differences between the two:

    Merchant Account Providers

    Merchant account providers are the more traditional type of payment processor. Unlike payment service providers, merchant account providers create separate bank accounts for businesses, hence their namesake. This is the account where your revenue from debit and credit card transactions will be deposited. Your provider will help you set up the account and show you how to use it.

    Merchant account providers also offer the hardware and software required for accepting payments. They sell POS systems, payment gateways, and credit card terminals.

    Since working with merchant account providers involves an entirely new bank account, the application and transition process is significantly longer than payment service providers. Merchant processing rates, however, will likely be lower for merchant account providers.

    Payment Service Providers

    This is the category that includes popular POS systems like PayPal, Square, and Stripe. Instead of setting up new merchant accounts, payment service providers deposit revenue from debit and credit card transactions into your existing business bank account.

    Setting up and using payment service providers is much quicker and less complicated than merchant account providers. Payment service providers also usually have flat rates, regardless of the business’s size or product prices. These rates tend to run higher than merchant account providers. But for many business owners, the ease of using payment service providers greatly outweighs the higher fee. And remember: In addition to basic merchant processing services, you’re also getting the software to help manage cash flow.

    Price Structures For Merchant Services

    You may have noticed an increase in businesses that use POS systems, most notably Square. This is primarily because merchant account providers’ pricing system is notoriously complicated and extremely unfair for many business owners. Two similar businesses that use the same merchant account provider could have completely different rates. Merchant account providers are also known to lack transparency when it comes to explaining their pricing systems.

    POS systems, on the other hand, clearly explain their pricing systems on their websites. But regardless of which merchant processing service you use, your price will depend on the provider, the type of services you need, and how you use them.

    Let’s say two companies choose to use Square. One company is a brick and mortar business, while the other is purely eCommerce. Since the first company requires a register-based system for in-person payments, the cost will be significantly different than a company that only needs to process online payments. The price difference also stems from the difference in credit card processing fees, which are just components of merchant processing services’ overall cost.

    Though credit card processing fees are displayed as one fee, they’re comprised of numerous charges involving the issuing bank, the credit card provider, the receiving bank, and the payment processor. These four parties are compensated for every debit or credit card transaction you process. The combination of each fee makes up your transaction fee. You will also have to pay recurring flat fees, one-time, flat fees, and incidental fees.

    In summary, credit card processing fees are made up of transaction fees, flat fees, and incidental fees.

    Here are the most common payment structures for merchant processing services:

    Tiered Pricing

    With tiered pricing, the cost of each transaction is based on the amount of risk involved. Each payment processor has its tiers, which are associated with different levels of risk. The specific criteria for what’s considered “risky” varies from processor to processor. Most processors, however, use relatively similar criteria. One typical example of a high tier transaction is online credit card payments. This transaction’s cost would likely be substantially higher than, say, an in-person debit card payment due to the lower likelihood of fraud.

    For this reason, tiered pricing usually works best for brick and mortar businesses that do not sell online. Other types of companies would likely find tiered pricing to be the most expensive pricing structure.

    Interchange-Plus Pricing

    Earlier, we noted that credit card processing fees are several smaller fees, such as the transaction fee. Well, the transaction fee is made up of smaller fees as well. Two of these smaller fees are the interchange rate and the assessment fee. The combination of the interchange rate and the assessment fee is known as the interchange fee.

    With interchange-plus pricing, your cost is the payment processor’s interchange fee plus a fixed percentage or fee per transaction. In other words, the “plus” part could be a percentage like 20%, or a dollar amount like $0.15.

    Some payment processors charge monthly subscription fees on top of the interchange fee and fixed fee per transaction. Others charge a fixed percentage and a fixed fee instead of one or the other. With both, you’d essentially pay three fees instead of the usual two.

    While interchange-plus pricing can get complicated, your monthly statements will clearly state how much you paid for each charge and why you paid that amount. You’ll see exactly how much money went to the payment processor and how much went to the credit card network.

    Due to its transparency and lack of risk-based tiers, interchange-plus pricing is widely considered the most desirable pricing structure.

    Flat Rate Pricing

    Flat rate pricing usually charges a small, fixed percentage of the transaction plus a small, fixed fee per transaction. You’ll pay the same percentage and fee regardless of the type of debit or credit card involved. These rates may differ, however, for in-person and online transactions, depending on the payment processor. Some payment processors even omit the fixed fee, so you’d only pay the fixed percentage of the transaction.

    Flat-rate plans tend to cost more than interchange-plus, but the combination of simplicity and transparency is difficult to pass up. It’s much easier to budget for your total monthly or annual payment processor expense with flat-rate pricing. Lots of new businesses use flat-rate plans because they don’t have the revenue or time in business to negotiate lower rates with the other two structures. Flat-rate plans will also likely be your cheapest option if you sell more inexpensive products.

    One-Time, Recurring and Incidental Fees

    The merchant services industry is notorious for hidden fees. Many business owners have made the mistake of believing that hardware, software, and credit card processing fees are the only expenses associated with merchant services. Most payment processors charge numerous additional flat fees, like the aforementioned monthly subscription fee.

    Here are the most common one-time, recurring, and incidental fees:

    • Account setup fee: This is a fee for merely opening an account.
    • Account fees: Most payment processors charge a monthly or annual fee for their services.
    • Minimum processing fee: Some processors charge a fee if you don’t meet a threshold for transactions or funds within a specific time frame.
    • Statement fee: Some processors charge a fee to provide financial statements (income statement, profit and loss statement, balance sheet).
    • PCI-compliance fee: This fee covers the credit card company’s cost of ensuring your compliance with industry security standards.
    • Cancellation fee: Some processors charge a hefty fee if you cancel your account before your contract ends.
    • Cardholder dispute fees: This fee is charged whenever a customer disputes a transaction.
    • Chargeback fees: If a customer dispute results in a chargeback, you may face another charge on top of the cardholder dispute fee.
    • Withdrawal fee: Some processors charge fees for transferring funds from your merchant accounts to your regular business bank account.
    • NSF fee: A “non-sufficient funds” fee may be charged if your business bank account doesn’t have enough funds to pay your processor.

    Disputable Fees

    Most legitimate payment processors will omit or not even charge fees for account setup, statements, minimum processing, and cancellation. This last fee can be huge, so make sure to ask about it before signing a contract. You may also be able to negotiate your way out of paying for specific hardware pieces, whether you are renting or purchasing it.

    Regardless of which processor you work with, it would be best if you always asked for clarification regarding fees. You’d be surprised at the charges you can avoid if you ask.

    What Are The Average Credit Card Processing Fees?

    On average, you should probably expect to pay between 1.7% and 3.5% per transaction. This money goes to the issuing bank, receiving bank, credit card network, and payment processor. Speaking in dollar amounts, the percentage could equate to anywhere from $1 to $5, depending on your products’ price. For example, let’s say your transaction fee is 2%, and a customer spends $50. In this case, you would take home about $49. If your product costs $200, on the other hand, you will take home $196.

    It’s harder to calculate an average for flat fees because they vary tremendously from processor to processor and business to business. Two businesses that use the same processor could pay very different fees. Monthly account fees can cost as high as $100, whereas incidental fees like cardholder dispute fees and NSF fees are usually much cheaper. But one business could very well have a monthly account fee closer to $10.

    Shopping For Merchant Processing Services

    Shopping for merchant processing services is a lot like shopping for small business loans. There are hundreds of merchant service providers to choose from. Having so many options can certainly be overwhelming, but it also allows you to find the right provider for your specific circumstances.

    The key to finding the right provider isn’t spending all of your time examining different options. Instead, it would be best if you devoted this time to answer a series of questions about your business. This will show you the kind of providers you should look for and compare.

    The first question to answer is the nature of your average customer payment. Do you mostly accept in-person payments, online payments, or an even mix of both? Then, consider how your customers make these payments. Do most of them use debit cards, credit cards, or both?

    Once you’ve answered these questions, you can look into hardware or software. Do you need a full POS system or just a single credit card terminal? Remember, eCommerce businesses only need a payment gateway.

    Finally, compare the pricing structures of your most sensible options. It’s crucial to pay special attention to fees at this stage. The option with the lowest processing fees may have higher flat fees. In summary, your cheapest option might not be immediately apparent.

    Merchant Processing Services: Making Your Decision

    Businesses that take the time to find the right provider for their needs have a significant financial advantage. Credit card processing fees will likely turn out to be one of your most significant annual expenses. Thus, you should prioritize this expense when starting your business and revisit it as your business grows. After all, the nature of your customer payments will likely change in the coming years. For example, it’s not uncommon for a company to change providers when selling products online, or when their online sales catch up with in-person sales.

    Different merchant service providers also present their rates and fees in different ways. This is why you should never be afraid to ask for clarification. You’ll probably have to make a few phone calls to get the information you’re looking for. Like every other significant expense, you must prepare to devote as much time as necessary to ensure that you choose the right option. Failing to do so can have dire consequences.

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