Your guide for the world of payment processing

Last Updated on October 17, 2024 by Kaitie Weaver

Remember the days when you needed to hit up the ATM to make sure you always had some cash at hand? Now many of us don’t even carry a wallet, let alone cash. Debit and credit cards, online shopping, mobile and wearable contactless payment methods have all pushed us toward an increasingly cashless society and the increased need for payment processing service continues to rise.

According to Juniper Research, cashless payment transactions globally are estimated to reach a value of $10 trillion by 2027, from $4.6 trillion in 2022. Indeed, consumers expect most businesses to accept cashless and digital payment methods making it important for your business to understand the complex world of payment processing.

Let's dive in!

What is payment processing?

The term ‘payment processing’ refers to the steps involved in transferring funds from one party to another. The easiest example is your everyday debit transaction. You tap to pay at the grocery store and money gets moved from your bank account over to the grocery stores.

This process feels almost instantaneous. You’ll often be able to see the transaction in your account right away. Regardless of its perceived simplicity, there is a complex system ensuring that funds get moved safely and securely and end up in the right place. This is payment processing.

Who are the key players in payment processing?

Before we get too deep into how a transaction works, let’s quickly review the many players in the payment processing game and how they work together.

• Customer: Initiates the transaction with a credit card or debit card.
• Merchant: Accepts the payment via a POS system.
• Payment processor: Partners with the merchant to facilitate the transaction via a merchant account.
• Issuing bank: The customer’s bank that provides the credit or debit card.
• Acquiring bank: The merchant’s bank that receives the funds.

Each player plays a crucial role in ensuring secure and efficient credit card payments and transactions.

High level: How does payment processing work?

Payment processing involves several stages, including authorization, authentication, and settlement. Here's a complete breakdown of each stage:

1. Authorization

This is the initial step where the payment information provided by the customer (such as credit card details) is verified and validated for availability of funds. The processor communicates with the customer's bank or card issuer to ensure the account has sufficient funds and is not flagged for any suspicious activity.

2. Authentication

To enhance security and prevent fraud, authentication methods like two-factor authentication (2FA), a PIN, address verification systems (AVS), or (increasingly) biometric verification like a palm print may be used. These measures help to ensure that the person initiating the payment is indeed the authorized cardholder.

3. Capture

After the payment is authorized, the actual transaction amount is reserved (or "captured") from the customer's account. This step confirms that the funds are available and ready for transfer. Sometimes this shows up on your banking app as a “pending” transaction.

4. Clearing

The clearing step of the process involves the exchange of transaction details and funds between the customer's bank (the issuing bank) and the merchant's bank (the acquiring bank). The transaction data is sent to the appropriate payment networks (like Visa, Mastercard, etc.) for further processing.

5. Settlement

During settlement, the funds are transferred from the customer's bank to the payment processor who will then deposit the funds into the merchant’s account. This finalizes the payment and completes the transaction. Settlement can occur within a few business days, depending on the payment method and financial institutions involved. The bank branch will then allocate the funds to the appropriate accounts.

6. Notification

Once the settlement is complete, both the customer and the merchant typically receive notifications of the successful transaction. Receipts or confirmation emails may be sent to the customer, while merchants may receive notifications of the completed payment once their payment processor has deposited their funds.

How long does payment processing take?

For all the complexities, components and players involved in payment processing it is fairly amazing how quick a transaction can feel. For a coffee shop barista, the time it takes for a customer to pay for a latte takes a matter of seconds. But behind the scenes, the time it takes to exchange money from one account to another can vary.

Typically, funds are captured immediately, but settlement may take a few days. Factors influencing this include the payment method used (credit card, debit card, ACH/EFT payments), the banks involved, and the payment processor’s policies.

A step-by-step example of payment processing in everyday life

Okay, let’s illustrate how payment processing works by using a super relatable example: You’re buying your morning cup of coffee at a coffee shop using a credit card.

Step 1: You place your coffee order

So, you hit up your favorite coffee shop for your morning coffee. If you’re like me, by the time you reach the barista you’ve talked yourself into getting a muffin too. The coffee shop employee takes your order and enters it into the POS system.

Step 2: The barista enters the item and calculates your total

The system calculates the total amount for the coffee and muffin based on the price of the item. They’ll then generally ask how you want to pay (cash, gift card, credit, and debit are normal). More and more of us will choose a contactless payment method. Let’s say you choose to pay today with your credit card.

Step 3: The barista passes you the terminal

The barista will select the credit card payment option on the POS system and hand you a credit card machine. You’ll often be prompted to add a tip, then accept the final ‘Total’ and you either tap, swipe, or insert to pay. Occasionally, you will be asked to insert your card and enter a PIN to verify your card. You’ll then notice the POS system goes into “Processing” and/or “Authorizing” mode.

Step 4: The POS sends an authorization request

Now, we get into what happens on the back end: When the POS is authorizing your transaction in those milliseconds after you tap, and before the transaction is ‘complete,’ the POS system sends an authorization request to the payment processor.

This request includes the transaction amount, the credit card number, the expiration date, and other relevant details.

Step 5: Authorization verification

The payment processor receives the authorization request and detects which card brand the customer is using (i.e Visa) and sends it to them who then forwards it to the customer’s issuing bank. The issuing bank verifies whether the customer's credit card has sufficient funds and is not flagged for any suspicious activity.

Step 6: Authorization response

The issuing bank sends an authorization response back to the card brand network to pass on to the payment processor. If the transaction is approved, the response includes an authorization code. If declined, the response includes the reason for the decline.

Step 7: Transaction approved, payment capture & (optional) receipt printing

If the transaction is approved, the payment processor sends an approval message to the POS system. The coffee shop employee sees the approval message on the POS screen and will usually offer you a receipt at this point.

The coffee shop employee confirms the transaction and captures the payment. This means the authorized funds are reserved on the customer's credit card for the coffee purchase.

The POS system prints a receipt for the customer, indicating the successful payment. The receipt may also show the transaction details, including the amount paid, the date, and the authorization code. From your perspective, the coffee and muffin are paid for and it’s time to enjoy! But that’s not the end of the story…

Step 8: Transaction settlement

During the settlement period, the payment processor initiates the process to transfer the authorized funds from the customer's issuing bank to the coffee shop's acquiring bank (merchant bank) which will allocate it to the merchant's account. This will typically happen when the coffee shop closes their tills at the end of the day, reconciles their transactions between their receipts and POS software, and “settles” their batches on their card readers.

Step 9: Funds transfer

Finally, the funds from the customer's credit card are transferred to the coffee shop's merchant account. This happens after all the transactions for the day have been settled on the coffee shop’s card reader and all the transactions have been released by the payment processor. This completes the payment process, and the coffee shop has successfully received payment for the coffee.

In this example, the coffee shop used a POS system to process the payment for the cup of coffee. The payment processor acted as the intermediary between the coffee shop, the customer's credit card issuer, and the relevant payment networks to ensure a secure and authorized transaction.

Why does payment processing matter for businesses?

Since payment processing is not something businesses can do on their own, having a trusted payment partner is vital for businesses to get paid. Having a seamless checkout process can elevate a businesses customer experience and set them apart from the competition; ultimately improving cash flow. A reliable processor can also enhance security, reduce fraud risks, and offer valuable insights through analytics for your business.

How to choose the best payment processing company

1. Understand your needs & research your options

Payment processing solutions can differ so you’ll first need to understand how you want to accept payments. Accepting credit cards, debit cards, and bank transfers are all different payment methods you can consider for your business.

On top of payment methods, you’ll want to think about whether you need an online or in-person solution, and if you have specific requirements like recurring payments or international transactions. Once you understand your business’ needs, research each payment processing service to get an understanding of their features, fees, and integrations and make an initial shortlist.

2. Compare fees and pricing

Unfortunately even some of the "best payment processing companies" can be notorious for hidden charges and high transaction fees. Pay attention to any unnecessary fees, which may include, PCI fees, monthly fees, chargeback fees, and more. Pricing structure can also make a huge difference when you're trying to save your business money.

Some processors have flat-rate pricing, while others have tiered or interchange-plus pricing models. Generally speaking Interchange Plus pricing can save businesses 25% avg. over flat rate processors so keep an eye out for a partner that has this type of fee structure to help save your business money.

3. Check security and compliance

Ensure the payment processing solution complies with industry security standards (like PCI DSS) to protect your customers' payment data. Look for features like encryption, tokenization, and fraud prevention tools which can not only offer you lower interchange rates but help protect your business and customer payment details and transaction data.

4. Check for integration and APIs

If you have an eCommerce website or plan to integrate the payment processing systems with other software, check if the processor offers APIs or easy integration with popular platforms like Shopify, WooCommerce, or your point-of-sale system.

5. Evaluate customer support

Consider the quality and availability of the payment processors customer support. Having reliable customer service can be crucial, especially if you encounter technical issues or need assistance with your account.

6. Determine compatibility with payment methods

Ensure that the payment processor supports the payment methods that your customers prefer. This could include debit and credit card payments, digital wallets, ACH transfers, and more.

7. Understand the settlement time

Understand the settlement period – the time it takes for funds to be transferred from the processor to your business's bank account. Faster settlements can improve your cash flow.

8. Research payment processor reviews and reputation

Look for reviews and feedback from other businesses that have used the payment processor. Consider their experiences and satisfaction levels.

9. Review the contract terms

Review the terms of any contracts or agreements. Some processors might require long-term commitments or have cancellation fees. Having to sign a contract can make it extra tricky to break away from the relationship if things go sour. Before moving forward with any processor make sure you're comfortable with the terms, but we’d recommend sticking with processors that don't lock you into any contracts like Helcim.

10. Check for additional services & scalability

Choose a payment processor that can grow with your business. As your sales volume increases, you'll want a solution that can handle larger transaction volumes.

In that vein, some payment processors offer additional services like invoicing, subscription management, and analytics. If these align with your business needs, they could be valuable.

FAQs

What is a third party payment processor?

A third-party payment processor handles transactions on behalf of merchants. They provide tools and services that allow businesses to accept various payment methods without needing their own payment infrastructure. This can reduce administrative operations, reduce costs, making it easier for businesses to focus on their core activities.

What is payment processing software?

Payment processing software is a tool that enables businesses to accept and manage payments. This software can handle transactions, track sales, and offer analytics. It often integrates with point-of-sale systems or eCommerce platforms, simplifying the payment experience for both businesses and customers.

What is the difference between a payment gateway vs. payment processor?

While often used interchangeably, a payment gateway and a payment processor serve different roles:

• Payment Gateway: This is a technology that captures and transfers payment data. It connects the customer’s payment method to the processor for approval.
• Payment Processor: This handles the transaction once the gateway captures the payment information, managing the actual movement of funds between banks.