Hidden Costs of Credit Card Processing

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Do you know what you are paying for credit card transaction processing? Of course, you review the statements from your payment processor and tally the fees from those reports. But do those fees tell the whole story? Are they the fees you expected to pay, do they make sense and are they calculated as they should be?


Chances are good that they are not.


Most hidden costs are associated with processing "bank card" transactions; i.e., for those purchases made with Visa and MasterCard. Purchases made with American Express, Discover and specialized "T&E" cards like Carte Blanche are handled directly by the card issuers, which have less opportunity to introduce questionable fees. With bank cards, however, there are a number of players between you and the card issuer, including the bank card associations (Visa and MasterCard), your merchant bank and your payment processor. We therefore will limit our discussion to bank card processing, where the opportunity for untoward business practices is the greatest.


When a customer uses his Visa or MasterCard to buy a product or service, you pay a fee. This fee is split by three of the players involved in handling the transaction. The largest portion of this fee, the "interchange," goes to the card issuer and is based on a percentage (e.g., 1.8 percent) of the purchase plus a small transaction fee (e.g., 10 cents). The smallest portion (less than 0.1 percent) goes to the card association and is called the "assessment." Your payment processor also charges you a fee -- and depending on your pricing and reporting structure, this fee could be almost anything. What's more, because your processor is your direct interface into the bank card system, it is generally responsible for providing you with an accounting covering all of the players.


Your processor may charge you a per-transaction fee for each purchase, or "bundle" its fee with the interchange and assessment and call the resulting charge a "discount." The discount can be a flat percentage or, like the interchange, it might consist of a percentage fee plus a per-item charge. Call it what you want, but if your fees are bundled and contain a percentage component, it is virtually impossible to discern what you are paying the individual players.


This becomes important when you consider debit cards, which, since August 2003, have enjoyed a lower interchange rate. If you are paying a bundled rate, and this rate did not decrease in August, you likely are missing out on a rare interchange reduction opportunity. You even may be paying up to 25 basis points in extra interchange on up to 50 percent of your orders (before recent rate increases, this differential was as high as 1 percent). Instead of going to you, this interchange windfall stays with your payment processor.


The problem with downgrades. Interchange is somewhat of a misnomer. It is really a general term describing dozens of rates legislated by the card associations. It's not just the type of card you are processing that can affect the interchange rate; the rate varies depending on factors related to the sale (Card Not Present, for instance) and the way the charge is processed. When a transaction fails to meet all of the necessary standards, the merchant receives a less-than-optimal interchange rate. This is known as a "downgrade."


Most likely, your payment processor will report downgrades as "non-qualified" transactions. Unfortunately, many processors simply lump all of the downgrades together and report them as a miscellaneous fee. Rule of thumb: If your downgrades or miscellaneous fees exceed 10 percent, you have a problem.


You see, to protect the integrity of their system, the associations do not publish their rules and regulations, including the dozen or so processing standards required to qualify for the lowest interchange rate. It's up to your payment processor, which is privy to these rules, to know and implement them to your benefit.


A high downgrade rate may indicate that your processor does not know the standards or that it may be reluctant to implement best practices or new rules changes. Be advised, however, that such problems also may be due to the way you process your orders, and may have little to do with your payment processor. Even if the cause originates with your business practices, your processor should be reviewing your account and suggesting ways to reduce these downgrades.


If you pay a bundled discount rate, you should pursue different pricing terms. You should insist on paying for the interchange and assessments on a "pass-through" basis. Under this scenario, you and your processor agree to an independent fee that the processor gets for each transaction. It can be percentage-based or transaction-based. What's important is that all fees to third parties are passed through to the merchant as incurred. Of course, good reporting plays a big role in making this system work and is important in quickly identifying downgrade issues.


The refund trap. What happens to the interchange when you process a refund? According to a common interpretation of various association regulations, the card issuer should return the interchange to the merchant. As a matter of workflow, the issuer actually returns the interchange to the payment processor. In many cases, however, the payment processor keeps the return interchange. You may be proud that you negotiated that super-duper low discount rate, but do you know where your interchange is?


If your refunds average more than 10 percent of sales, this missing rebate can add up. Let's say your processor charges a 2.3 percent discount rate. If it is not rebating interchange on returns, that 2.3 percent can become an effective rate of 3 percent or higher! Of course, average ticket price must be considered in the calculation, but you can see the potential for this hidden cost.


Dial-up blues. If you still use a dial-up connection to connect to your processor, there are other possible charges to beware of. Many payment processors offer some sort of "fast-batch" authorization. This method provides a quick, one-hop process for processing large numbers of authorizations per session. It provides for real-time processing by the card associations without the need to drop off files and pick them up later.


Fast-batch can be a great way to process authorizations, but merchants must use caution when using this method over dial-up lines. Any time there is an interrupted transmission (a "line drop," which happens frequently with older modems), the batch must be retransmitted, and, of course, if some of the orders that were already authorized in the preceding transmission are authorized again, you will be charged a second time for them (or more, if it happens multiple times!). Worse, your customer's credit limit will be reduced each time the authorization is retransmitted.


How big of a deal is this? One merchant whose accounts we audited was paying more than $120,000 a year in excess charges based on his processor's mismanagement of fast-batch transmissions.


How can you tell if you have a potential problem? A reasonable standard for authorizations is that they should not exceed 110 percent of sales. In other words, for every 10 orders you should have about 11 authorizations. This extra 10 percent provides for decline resubmissions and renewal of authorizations for shipping back orders after the original authorization has expired. Individual merchants may normally have higher rates, especially those involved with recurring payments. Regardless of your transmission method or business type, if your authorization ratio exceeds 130 percent, you should have a closer look.


Pay attention. How can you avoid hidden fees? In general, you can build your own benchmarks and evaluate the cost-effectiveness of your own business rules and other factors. But above all, work with your processor to ensure that you understand the basis on which you are being charged for your credit card processing, and ensure that you can monitor and audit those charges on an ongoing basis to achieve continuous improvement.


Finally, if you are billed for your credit card processing on a pass-through basis, as we suggested above, you also can monitor the fees you are paying your processor, as well as the other players. That should help you not only set standards and benchmarks, but reduce or eliminate the possibility you are being unnecessarily or routinely downgraded or otherwise victimized by hidden processing charges.


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