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What is Payment Processing? Your Complete Guide

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Ryleigh Stangness | September 8, 2023

“Explore the world of payment processing from cash to digital. Learn how it works and why it's crucial for your business.”
19 min read
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    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, and mobile and wearable contactless payments have all pushed us toward an increasingly cashless society.

    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, we all expect most venues and vendors to accept digital payment methods including debit card transactions and credit card transactions.

    On the consumer side, this means a simple tap, swipe, or even a biometric payment (e.g., using your palm) that takes mere seconds. But on the back-end, there’s a complex system of authorization, verification, settlement, etc. that’s known as payment processing.

    High level: What Is payment processing?

    The term ‘payment processing’ refers to the steps involved in transferring funds from one party to another, typically as a result of a financial transaction. The easiest example is your everyday debit transaction: You tap to pay at the grocery store. Money gets moved from your bank account over to the grocery store.

    Think about it: This usually happens almost instantaneously. You’ll often be able to see the transaction on your account right away. But there’s also a complex system ensuring that funds get moved safely and securely and end up in the right place. This is payment processing.

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

    1. Authorization

    This is the initial step where the payment information provided by the customer (such as credit card details) is verified for validity and availability of funds. The payment 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.

    Okay, so what is a payment processor?

    Hello! That’s us 🙂

    A payment processor is a company (like Helcim) that handles the technical and financial aspects of processing payment transactions on behalf of merchants and businesses.

    Payment processors play a crucial role in facilitating the transfer of funds from customers to merchants securely and efficiently. They act as intermediaries between various parties involved in a transaction, including customers, merchants, banks, and payment networks.

    Payment processors offer a range of services, including credit and debit card processing, digital wallet payments, bank-to-bank transfers, mobile payments, Point of Sale (POS) systems, and even support for emerging technologies and digital payment methods. .

    Here's a more detailed breakdown of the functions and role of a payment processor:

    Authorization

    Payment processors verify the customer's payment information (like credit card details) to ensure that the funds are available and the transaction can proceed. They communicate with the customer's issuing bank to obtain authorization for the transaction.

    Security

    Anything to do with money, banking, and payments requires a high degree of security. Payment processors also implement stringent security measures to protect sensitive payment information and prevent fraud. This can include encryption, tokenization, and fraud detection systems.

    Transaction routing

    It’s not just money that’s moving around, information about the transaction needs to be transmitted too: Payment processors route the transaction data to the appropriate payment network (e.g., Visa, Mastercard) to ensure that the payment method is supported and the transaction follows the proper protocols.

    Capture and settlement

    Payment processors help capture the authorized funds from the customer's account and facilitate the settlement process. Settlement involves transferring the funds from the customer's bank (issuing bank) to the merchant's bank (acquiring bank).

    While settlement is typically done within a few days, payment processors may have to hold funds for longer. They typically deposit a merchant’s funds into their merchant account on a bi-weekly or monthly cadence, unless the transaction has been flagged for fraud or a potential chargeback. This step is important as payment processors can help prevent merchant’s from being caught up in fraudulent transactions or paying chargebacks reimbursement funds to fraud victims from stolen cards for example.

    However, disruptions to this cadence can be really frustrating for business owners, especially those who are dependent on their cash flow or trying out a new way of getting paid. The good news is that these situations usually get sorted out pretty quickly, depending on the company that handles your payments.

    For instance, if you have your own merchant account for handling payments and your payment processor checks things carefully before letting you process transactions, then you're less likely to run into problems like sudden holds on your money. On the flip side, some companies that make it quick and easy to sign up might also be really quick to shut down your account if anything seems fishy.

    When you also consider that you might end up waiting on the phone for a long time and dealing with unhelpful customer service, picking the wrong payment company can turn a simple thing like an unusual way of paying or an odd amount of money into a super frustrating situation. And that frustration can actually mess up how money flows in and out of your business.

    Payment gateway integration

    Many payment processors offer payment gateway services as part of their offerings. A payment gateway is a software application that connects the merchant's website or point-of-sale system to the payment processor, enabling online transactions and real-time authorization.

    Reporting and analytics

    Payment processors often provide merchants with reporting and analytics tools to track transaction data, monitor sales trends, and manage their financial operations.

    Customer support

    Payment processors offer customer support to both merchants and customers in case of any issues, disputes, or inquiries related to payment transactions helping to resolve concerns and avoid chargebacks.

    Compliance

    Payment processors ensure that their services comply with industry standards and regulations, including data security standards like PCI DSS (Payment Card Industry Data Security Standard). (P.S. you shouldn’t be paying for PCI fees. Read more to find out if you are overpaying on extra fees here.)

    It's time to save with Helcim

    A step-by-step example: How does payment processing work?

    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.

    Customers can order coffee through a 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 cards, 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.

    When you make a purchase, your credit card details travel through the payment processing system to various checkpoints before being approved

    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.

    After a transaction has been authorized by a payment processor, card networks, and issuing/acquiring banks a merchant will see the approval (or declined) message on their POS

    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 “settle” 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.

    There are various checkpoints, networks and institutions involved in processing payments 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, and mobile and wearable contactless payments have all pushed us toward an increasingly cashless society.

    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, we all expect most venues and vendors to accept digital payment methods including debit card transactions and credit card transactions.

    On the consumer side, this means a simple tap, swipe, or even a biometric payment (e.g., using your palm) that takes mere seconds. But on the back-end, there’s a complex system of authorization, verification, settlement, etc. that’s known as payment processing.

    High level: What Is payment processing?

    The term ‘payment processing’ refers to the steps involved in transferring funds from one party to another, typically as a result of a financial transaction. The easiest example is your everyday debit transaction: You tap to pay at the grocery store. Money gets moved from your bank account over to the grocery store.

    Think about it: This usually happens almost instantaneously. You’ll often be able to see the transaction on your account right away. But there’s also a complex system ensuring that funds get moved safely and securely and end up in the right place. This is payment processing.

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

    1. Authorization

    This is the initial step where the payment information provided by the customer (such as credit card details) is verified for validity and availability of funds. The payment 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.

    Okay, so what is a payment processor?

    Hello! That’s us 🙂

    A payment processor is a company (like Helcim) that handles the technical and financial aspects of processing payment transactions on behalf of merchants and businesses.

    Payment processors play a crucial role in facilitating the transfer of funds from customers to merchants securely and efficiently. They act as intermediaries between various parties involved in a transaction, including customers, merchants, banks, and payment networks.

    Payment processors offer a range of services, including credit and debit card processing, digital wallet payments, bank-to-bank transfers, mobile payments, Point of Sale (POS) systems, and even support for emerging technologies and digital payment methods. .

    Here's a more detailed breakdown of the functions and role of a payment processor:

    Authorization

    Payment processors verify the customer's payment information (like credit card details) to ensure that the funds are available and the transaction can proceed. They communicate with the customer's issuing bank to obtain authorization for the transaction.

    Security

    Anything to do with money, banking, and payments requires a high degree of security. Payment processors also implement stringent security measures to protect sensitive payment information and prevent fraud. This can include encryption, tokenization, and fraud detection systems.

    Transaction routing

    It’s not just money that’s moving around, information about the transaction needs to be transmitted too: Payment processors route the transaction data to the appropriate payment network (e.g., Visa, Mastercard) to ensure that the payment method is supported and the transaction follows the proper protocols.

    Capture and settlement

    Payment processors help capture the authorized funds from the customer's account and facilitate the settlement process. Settlement involves transferring the funds from the customer's bank (issuing bank) to the merchant's bank (acquiring bank).

    While settlement is typically done within a few days, payment processors may have to hold funds for longer. They typically deposit a merchant’s funds into their merchant account on a bi-weekly or monthly cadence, unless the transaction has been flagged for fraud or a potential chargeback. This step is important as payment processors can help prevent merchant’s from being caught up in fraudulent transactions or paying chargebacks reimbursement funds to fraud victims from stolen cards for example.

    However, disruptions to this cadence can be really frustrating for business owners, especially those who are dependent on their cash flow or trying out a new way of getting paid. The good news is that these situations usually get sorted out pretty quickly, depending on the company that handles your payments.

    For instance, if you have your own merchant account for handling payments and your payment processor checks things carefully before letting you process transactions, then you're less likely to run into problems like sudden holds on your money. On the flip side, some companies that make it quick and easy to sign up might also be really quick to shut down your account if anything seems fishy.

    When you also consider that you might end up waiting on the phone for a long time and dealing with unhelpful customer service, picking the wrong payment company can turn a simple thing like an unusual way of paying or an odd amount of money into a super frustrating situation. And that frustration can actually mess up how money flows in and out of your business.

    Payment gateway integration

    Many payment processors offer payment gateway services as part of their offerings. A payment gateway is a software application that connects the merchant's website or point-of-sale system to the payment processor, enabling online transactions and real-time authorization.

    Reporting and analytics

    Payment processors often provide merchants with reporting and analytics tools to track transaction data, monitor sales trends, and manage their financial operations.

    Customer support

    Payment processors offer customer support to both merchants and customers in case of any issues, disputes, or inquiries related to payment transactions helping to resolve concerns and avoid chargebacks.

    Compliance

    Payment processors ensure that their services comply with industry standards and regulations, including data security standards like PCI DSS (Payment Card Industry Data Security Standard). (P.S. you shouldn’t be paying for PCI fees. Read more to find out if you are overpaying on extra fees here.)

    It's time to save with Helcim

    A step-by-step example: How does payment processing work?

    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.

    Customers can order coffee through a 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 cards, 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.

    When you make a purchase, your credit card details travel through the payment processing system to various checkpoints before being approved

    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.

    After a transaction has been authorized by a payment processor, card networks, and issuing/acquiring banks a merchant will see the approval (or declined) message on their POS

    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 “settle” 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.

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