Where do credit card fees come from

I had a CPA tell me the the other day, “I’m a smart guy. I understand numbers, pricing and reconciliation, but for whatever reason I just cannot get my head around credit card processing fees.” He’s not alone. There is no doubt that understanding the fees that merchants pay to accept credit cards is very challenging. Hopefully this post will clear up some of that confusion. I’ll provide some context about where credit card fees come from, who’s making the money, and how they are determined.

Banks make roughly 80% of all credit card fees
To use a simple example, let’s say that a business is paying 3.5% to accept credit cards. Roughly 80% of that 3.5% in fees is going to the issuing bank, or the bank that gave the consumer their credit card. The rest of the 20% is divided among Visa/MasterCard, the credit card processor, and if there is one, the reseller, or ISO as they are referred to in the industry.

How do banks justify the fees they charge?
Let’s say that you bank at Chase and that they issued you your credit card. When you spend money with your credit card, Chase honors your purchases and pays the business you bought the good or service from. At the end of the month, Chase sends you a summary statement outlining all of your transactions and a due date to pay the outstanding balance. For you, it’s convenient to pay with a credit card, it’s secure with fraud protection, it’s helpful to get a monthly accounting of purchases, and it’s nice to have a 15 to 45 day float on the money that you spend (assuming you are paying your bills on time).

For Chase, it costs them money to pay for your purchases in advance of getting paid themselves, cover customer default and fraud losses, provide you customer service, and produce a monthly statement. It also costs them money when they offer you some sort of rewards program like cash back or frequent flyer miles. Chase recoups their cost and makes a profit by charging businesses a fee on every transaction their card holders make. Their fee is a part of ‘interchange’, or the wholesale cost of the credit card processing world. So back to our example, if you buy movie tickets for $20 and the movie theater is paying 3.5%, Chase would roughly make $0.56 ($20 x 3.5% = $0.70, they would get roughly 80% of that or $0.56).

What again is “Interchange”?
Interchange refers to the rates and fees that the banks and Visa/MasterCard collectively charge. So continuing with the ticket example, if Chase is making $0.56 on the transaction, and Visa is making another $0.02, then interchange would be $0.58. Resellers and credit card processors mark up interchange and sell the processing services to merchants and then pocket the difference between the rates charged and interchange.

That seems simple enough, why does everyone say it’s so complex?
Well, there are over 100 different interchange rates, and the interchange rate that is charged on any given transaction depends on five different variables:

1) What type of card is used in the transaction i.e. debit, credit, rewards, or business card.
2) Where the card is used i.e. restaurant, retail, gas, business to business, ecommerce, etc.
3) How the card is used i.e. swiped, over the phone, or via the internet.
4) What information the business captures during the transaction i.e. name, address, tax ID, tax amount, unit description, etc. (the information required is a whole other layer of complexity).
5) When the transaction is submitted to the processor for settlement and funds transfer.

As you can imagine, it’s a very complicated matrix. Very few people, including those who’ve been in the industry for years, really understand interchange.

Wasn’t there a lawsuit a few years ago about interchange?
Yes, Wal-Mart successfully started and won a class action lawsuit worth billions of dollars because the courts decided that interchange was being improperly priced. Wal-Mart and others claimed that debit card interchange should be priced less than regular credit cards because among other things debit cards cost less (i.e. banks don’t have to float purchases because debit cards have money immediately come out of their account). Visa and MasterCard had to pay Wal-Mart and other retailers billions of dollars in overcharged fees.

The outrage over credit card fees
Businesses are generally upset about credit card fees for two reasons. First, interchange has increased by a whopping 117% since 2001. Credit card fees are now one of the largest expenses retailers face in selling their goods. Second, even giants like Wal-Mart who have tremendous buying power have had very limited success dealing with interchange fees. You can see where the rub is when Visa and MasterCard control over 70% of all cards processed and businesses are essentially forced to accept credit cards in order to be in business.

You now understand why you find a credit card offer in your mailbox everyday. Outside of the 18% interest rates, annual fees, and late fees, being a card issuer is a lucrative business! You make money on both the front and back end.

One more layer of complexity to interchange: Downgrades
To briefly mention one more layer of the complexity, transactions can be ‘downgraded’ when they don’t meet interchange requirements. Reasons for downgrades include not capturing the correct information when processing, settling the transaction after a certain peroid of time, not swiping the transaction and many more.

For example, if an employee at a restaurant swipes your credit card on their terminal and it won’t read the magnetic strip, when the employee hand key’s the transaction it’s ‘downgraded’. Or in other words, the transaction is penalized because ‘non swiped’ transactions carry more risk and therefore higher fees. The difference in a ‘downgraded’ transaction can range from 30 to 90 basis points (100 basis points equals 1%), a significant penalty for any business. So instead of paying 1.79% and $0.25 on a particular swiped transaction, you would pay something like 2.4% and $0.25. Actual numbers vary according to what ever you have with your existing provider.

Downgrades are most frequenly seen with businesses that are ‘card not present’, such as ecommerce, business to business, and mail/telephone order. I don’t have hard data on this but I would estimate that the average business has somewhere between 20% and 50% of their transactions downgraded due to some reason.

Downgrades are the industry’s dirty little secret. It’s also where service providers make most of their margin because they don’t disclose these fees or make them legible on your monthly statement. My company is the provider in the industry that I know of that has created a specialty in helping companies minimize the number of downgrades they have (please pardon the plug, but it’s worth mentioning because it highlights a significant challenge for merchants and the unaligned incentives between providers and customers).

Your undecipherable monthly credit card statement
As icing on the cake, the unreadable format most credit card companies use to present this information to you on a monthly basis doesn’t help. Of course, the format used is not because they have no other option, it’s because that’s what makes them the most amount of money.

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