What is Payment Processing and How Does it Work?
As an eCommerce merchant, your entire business revolves around being able to take payments from customers online. While it may seem like a simple transaction - the customer enters their credit card information and magically the money ends up in your bank account in exchange for the product you are selling - there is actually a complicated process that must take place in the background.
It is important for business owners to understand the basics of payment processing and how exactly it works. You are responsible for your customers’ private financial information as soon as they enter their payment details on your site, so it is worth your while to be as informed as possible about the process in case any issues or challenges ever arise.
Most companies use a third-party payment processor in order to manage this behind-the-scenes process. Payment processors serve as the go-between facilitating the entire credit card transaction process between the bank and the seller. In simple terms, payment processing refers to the communication between the customer’s credit card and bank and the seller’s merchant account. The purpose of this communication is essentially to confirm that there are enough funds in the customer’s account to allow for the transaction to go through. While the entire digital payment process can be completed in a matter of seconds, there are multiple steps that have to happen to ensure that the transaction is completed and that the funds are truly transferred from buyer to seller.
Read on for more information about what happens behind the scenes when a customer makes a purchase and the payment processing system is set in motion.
Why Should You Use Payment Processing?
It is virtually impossible for an eCommerce merchant to operate today without a payment processing system in place. Obviously, you need to allow your customers to pay via credit card online, but you want to make sure that you have the infrastructure in place that allows these transactions to happen smoothly and securely, whether the customer is making a one-time purchase or signing up for a subscription requiring recurring payments.
The internet payment process in itself can be risky - anytime you accept a credit card or debit card payment online there is always the possibility (albeit it very small) that the cards are stolen or counterfeit. Would-be fraudsters are lurking around every corner looking for opportunities to turn a profit by taking advantage of unsuspecting merchants.
In addition, when you think about how do credit card payments work, keep in mind that these payments rely on “credit” - this means that as the seller, you will not receive funds immediately upon the customer providing their credit card information. Rather, you receive a type of “IOU” from the bank indicating that the customer will pay assuming that they have the funds available. If they do not, then the transaction will fail and the seller will not receive the funds.
A payment processor is needed to ensure that the payment processing itself runs smoothly. The processor also verifies the authenticity of the card and cardholder and facilitates all communication among and between any involved banks and credit card companies.
What are the Three Steps of Payment Processing?
Once a purchase is made, payment processing works in three steps before the funds are finally released. These steps are designed to verify that the credit card is valid, to protect the cardholder’s personal information, to confirm that the funds are available and to transfer the funds to the seller’s bank account.
The three steps of payment processing are authorization, authentication and settlement, with each one having its own mini-process as described below.
After a customer chooses the products they want to buy and reaches the checkout page, they are asked to enter their card information. At this point, the issuing bank of the credit card has to verify the account details and authorize the transaction.
The steps involved in this stage are:
- Customer enters card information (or inserts card into credit terminal if in a brick and mortar store as opposed to online)
- Card details are encrypted and sent to the acquiring bank (the bank used by the seller)
- The acquiring bank then sends the card details to the credit card association responsible for the card used (i.e. Visa, MasterCard or American Express)
- The credit card association provides approval for the payment request and asks the issuing bank (the customer’s bank) to authorize the transaction
- The issuing bank will authorize the transaction once it verifies the card number, expiration date, security code, billing address and total payment amount.
During this process, it is the payment processor that passes along the messages asking the banks and card associations for authorization. Although this sounds like a lot of steps, it generally only takes seconds or minutes to complete.
Once the issuing bank is satisfied that the card details are verified, it authenticates the purchase so that payment can be released to the acquiring bank. During this stage, the following steps take place:
- The issuing bank gives its approval and tells the credit card association
- The credit card association passes on the authorization to the acquiring bank
- The issuing bank puts a temporary hold on the customer’s account in the amount of the purchase - once the transaction clears these funds will be withdrawn and deposited in the seller’s account
- The customer will see a confirmation on the checkout page (or will receive a hard copy receipt in a brick and mortar store).
If, for any reason, the issuing bank does not approve the transaction, it will notify the card association and acquiring bank and the transaction will be canceled. The customer will see an error message, usually explaining the reason for the rejection.
In the final stage of payment processing, the issuing bank releases the funds and they are transferred to the seller’s account in the acquiring bank. It can take a few days for the transaction to settle and for the seller to see the funds. This settlement phase includes the following steps:
- At the end of each day, all approved authorizations from the day are sent to the acquiring bank.
- The acquiring bank passes this information to the credit card association.
- The credit card association works to settle each individual transaction, which involves getting the funds to the seller, removing the hold from the customer’s account and finalizing the transaction.
- The credit cards association sends the issuing bank notice of all approved transactions.
- The issuing bank transfers funds to the credit card association.
- The credit card association passes the funds on to the acquiring bank.
- The acquiring bank deposits the funds in the seller’s account.
- The issuing bank deducts the funds from the customer’s account and closes the transaction.
When Payment Processing Doesn’t Work
Billions of dollars in online payments are processed every day and while many do run as smoothly as the description above sounds, there are plenty of instances when serious challenges arise and the payment processing system breaks down. The biggest challenge is fraud, and it costs eCommerce sellers huge amounts of money through little fault of their own as it can be very difficult to identify fraudulent charges.
There are a few steps that eCommerce sellers can take to mitigate the risk of exposure to fraud and try to process card payments safely:
- Make sure that your payment processor is using PCI-compliant data security and protection. You do not need to be a cybersecurity expert, but you definitely want to be sure that your payment processor is up on the latest protections.
- Require customers to provide billing address, card expiration date and CVV code as additional verification data. The more data you ask for, the less opportunity there is for fraudulent behavior.
- Use SSL (secure sockets layer) certificates and other security measures like 3DS2 to protect the safety of all transactions on your online store. Most payment processors will require the use of SSL certificates for any eCommerce merchant that they work with.
- Make sure all of the hardware and software that you use is up to date and that all of the latest patches and security updates are installed.
Payment Gateway vs. Payment Processor
There are many different terms thrown around in the payment space. Some are used interchangeably but some have important differences. In order to fully understand payment processing, you also need to understand how a payment gateway works and what is the difference between the two.
A payment gateway is a software that takes care of the technical elements of transferring cardholder information from the third-party payment processor to the credit card company and back. Without a payment gateway, you cannot receive payments from customers even if you have a payment processor set up. While it’s the payment processor that authenticates and authorizes each transaction, the payment gateway is responsible for the logistics behind the actual transfer process.
Most payment gateways charge a fee for each transaction. Many eCommerce sellers choose to work with a payment service provider that provides them with access to a payment gateway. Pay.com is an example of a payment service provider that offers an end-to-end solution giving sellers the entire infrastructure that is needed to be able to accept payments online.
The Best Way to Approach Payment Processing
Options abound when it comes to choosing the payment processing solution that will work best for your business. The one thing that is certain is that you need to offer your customers a way to know how to make payments online and therefore you need a way to process those payments to ensure that you get your money.
Choosing whether to get your own merchant account or to use a payment service provider is a business decision based on the size of your business and volume of transactions. Larger businesses will need a more robust payment processing system and it is always a good option to work with a provider that can scale as your business grows.
How to Apply for Payment Processors?
There is no shortage of payment processors, so it is important to do your research thoroughly to find the option that works best for you. You can sign up to work with a payment processor through some banks, third-party online providers and companies such as PayPal that also offer payment processing services.
In conducting your research, here are some points you should keep in mind:
- Make sure that whatever payment processor you choose is compatible and can integrate easily with any other eCommerce software or other platforms that you are currently using.
- As discussed above, security is extremely important when it comes to online transactions, so make sure that you go with a PCI-compliant payment processor.
- Ask questions about the fraud prevention elements that payment processors you are considering have in place. You’ll want to choose one that is up-to-date on the latest threats and is always monitoring the situation and updating the protection it offers to you and your customers.
How is a Payment Actually Processed?
Now for the fun part…what does processing payment mean and how does payment processing work in practice? The truth is, it is a very simple process, at least on the outside. What happens behind the scenes is a little bit more technical, but that’s what the payment processor is there to help you with.
Here is a step-by-step look at what happens throughout the payment processing journey:
- The customer selects products to purchase online, goes to the checkout page and enters credit card information
- This financial information is transferred (preferably automatically, but can also be manual) by the seller to the payment gateway
- The payment gateway transmits the information to the seller’s payment processor
- The payment processor sends the transaction details to the relevant credit card network such as Visa, MasterCard or American Express
- The card network shares the information with the customer’s issuing bank which then checks to make sure the customer has the appropriate amount of funds to cover the transaction
- The bank responds to the card network with either an approval or rejection of the transaction
- The card network passes that response back to the payment processor which relays it to the payment gateway in order to inform both the seller and the customer of the response
- Assuming the transaction was approved, the funds are transferred from the issuing bank to the seller’s merchant account to await settlement and transfer to the business bank account.
The beauty of this process due to today’s technology is that it all happens within seconds. By the time the customer lifts his or hand off the mouse after clicking “submit” and sending their credit card information, the transaction may already be complete. It seems quick (and it is), but now you know about all of the complexities that are taking place in those few seconds.
Advantages and Disadvantages of Payment Processing
While there is no avoiding payment processing if you want to run a successful eCommerce site (or any business for that matter), there are both advantages and disadvantages to be aware of when it comes to using a third party payment processor.
First, the advantages, which include:
- Price - it can be very expensive to set up a merchant account and pay the associated operational fees. It is generally much more cost effective to use a third-party payment processor which will have a lower price both to set up and maintain.
- Setup - setting up a merchant account on your own is time-intensive and a bureaucratic and frustrating process. Using a third-party payment processor generally means a quick setup leaving you plenty of time to focus on running and growing your business.
- No minimums - most payment processors do not have minimum transaction requirements, meaning you can benefit from their help no matter how big or how small your business is.
The biggest downside to using a third-party payment processor at this point in time is probably that they are not yet as well-known or common as the traditional merchant account services. But, that is already changing and will continue to change as the entire payments industry shifts in tune with the newer generation of shoppers who are already used to using third-party processors themselves when they pay each other using Zelle or Venmo, for example.