Interchange Fees

There's no doubt that interchange is an intimidating topic, but it's one that you literally can't afford to bypass if your business accepts bankcards.

Interchange reimbursement is the term used to describe a schedule of fees that are the underlying basis from which all credit card processing charges are determined. It's not one of the most exciting topics, but it's a crucial subject to understand if you don't want to overpay for credit card processing.

This section will explain interchange thoroughly, and the next section, Merchant Account Pricing Models (coming soon), will explain how different merchant account pricing structures act upon the same interchange rates to yield widely varied bottom-line costs.

Once you're done with these two sections, you'll know if your merchant account provider has been enjoying inflated profits at your expense and what to do about it if they are.

Without an understanding of interchange fees, you have no basis from which to judge if your merchant account is priced competitively. Furthermore, you won't know how different merchant account pricing models act upon interchange to yield vastly different processing fees.

Without sugar coating things, without understanding interchange you won't be able to tell the difference between a great merchant account and a rip-off.

To drive the point home even further, I'll relate interchange to a more common example. Picture yourself walking into a bank to get a loan without having any concept of how interest rates are set or what the prime rate is. How would you know if you're being offered a good rate? You wouldn't, and the same is true for interchange and merchant accounts when it comes to processing credit cards.

Aside from being a source of headaches and confusion for many business people, interchange fees are the basis for credit card processing expenses. Think of them as the wholesale prices charged to process various types of credit card transactions.

Before I get into the specifics of interchange, it's important to understand what issuing and acquiring banks are and how they're crucial players in the credit card processing scenario.

First up is the issuing bank. As the name implies an issuing bank issues credit cards to consumers. If you have a credit card, like most people, you send your payment each month to your issuing bank. Bank of America and JPMorgan Chase are examples of large issuing banks.

Acquiring banks are on the side of the credit card transaction. Businesses open merchant accounts through acquiring banks, or companies backed by acquiring banks. For the sake of simplicity, we'll leave them out of the mix for now. Because acquiring banks are where businesses go to open a merchant account, they're often referred to as merchant banks. Merchant banks are also the institution that deposits funds from credit card sales into a merchant's business bank account.

When a customer (cardholder) uses their credit card to pay for products or services, the business's acquiring bank (where they have their merchant account) pays the customer's issuing bank a percentage of the gross sale amount. Depending on the brand of card being used, the percentage that they pay is dictated by either Visa or MasterCard's interchange reimbursement fee schedule (we'll leave other card brands such as American Express out of the mix for now).

So, in a single sentence; an interchange fee is the amount of a credit card transaction that an acquiring bank pays (or reimburses) and issuing bank.

Interchange reimbursement fees are set by Visa and MasterCard, or more accurately, by their stakeholders - both Visa and MasterCard are public companies. Not surprisingly, banks that issue credit cards and merchant accounts are the main stakeholders in both companies, JPMorgan Chase being the current largest issuer.

Once upon a time there were only a few interchange categories, but they've since grown to round a couple of hundred between the card brands.

There are three basic reasons for the number of interchange categories, the last of which I'll cover is a major factor behind the debate over interchange.

Risk is the primary reason for having different interchange categories. The lower the risk associated with a credit card transaction, the lower the interchange fee will be to process it and vice versa. For example, if you take a look at Visa's fee schedule, you'll see that a CPS/retail signature transaction carries an interchange fee of 1.54% plus $0.10, while a CPS/Card Not Present transaction carries a fee of 1.80% + $0.10. The retail transaction has a lower fee because it carries a lower risk factor for the banks that are moving the money around.

The next factors contributing the number of interchange categories is business type and processing behavior. Over the years the Card Associations have added interchange categories to accommodate specific types of businesses, and businesses with special needs - like those having consistently small or large average tickets. Take a look at Visa's fee schedule and you'll see categories for specific business types, such as supermarkets. You'll also notice categories for small and large ticket sizes.

The most controversial reason for the number of interchange categories is marketing. By creating separate, more expensive interchange categories for rewards credit cards banks are effectively passing the cost of these expensive programs on to merchants.

The problem is that merchants reap absolutely no benefit from the various credit card rewards programs that banks create. The only parties that benefit are the banks themselves, through new cardholder acquisition, increased retention and increase card use.

Rewards programs are a double-edged sword for merchants. They promote the use of credit cards over cash, and they cost merchants more to accept. The result is increased processing charges because of inflated fees and high volume.

Yes. Visa and MasterCard can update or change the interchange reimbursement fee schedule twice annually in April and October.

Once upon a time interchange fees were a closely guarded secret. Nowadays, you can view the complete schedules from Visa and MasterCard's websites. Follow the resource links at the bottom of this section to see for yourself - and you should.

If you value the money that your business makes, you should visit Visa and MasterCard's website twice a year in April and October when interchange fees change to download the current rate sheet.

Once again it's important to make the distinction between "merchant discount" and interchange fees. As a business, you pay a merchant discount fee to your merchant service provider. Think of the merchant discount fee as the retail price for credit card processing and interchange as part of the whole sale cost.

Merchant discount includes interchange fees, association dues, network access charges, profit for the merchant service provider and a few other things. Check the merchant account information guide for a detailed breakdown of the merchant discount fee.

Now that you've got an idea of what merchant discount is, let's get back to the question at hand. The issuing bank is the institution that collects interchange fees. Remember, that's the bank where the cardholder maintains their credit card account.

Well, it depends on who you ask and how far you follow the logic - but bear with me and I'll get to the point after a bit of maneuvering.

In their interchange rate sheet Visa states that, "Merchants do not pay interchange reimbursement fees; merchants pay "merchant discount" to their financial institution." Technically, this is true, but it's not the whole story. As described in the section above, merchant discount is a fancy term that's used to refer to the collective fees that a merchant pays to process a credit card transaction. Merchant discount includes the interchange reimbursement fee, assessments to Visa and MasterCard and additional fees from the provider or other financial institutions that may be involved in the transaction - like debit networks, for example.

So, a more complete yet simpler explanation of who pays interchange fees would be something along the lines of:

Acquiring banks (the merchant's bank) pay interchange reimbursement fees to the cardholder's bank (issuing bank) using funds they collect from merchants. What it boils down to is that merchants indirectly pay interchange reimbursement fees in addition to other fees imposed on their transactions.

Visa's interchange reimbursement schedule
Here it is in plain black and white (and a little orange and blue), all of the fees that any business accepting credit cards must pay. If your business accepts credit cards, you've got no excuse for not being familiar with schedule.

MasterCard's interchange reimbursement schedule
Ditto from Visa's paragraph above. The only difference is MasterCard's fees and color scheme.

Federal Reserve
This white paper by the Federal Reserve is pretty technical reading about interchange and the debates surrounding it. It's advanced reading on the topic, but well worth the time.

Wikipedia's Page on Interchange Fees
Wikipedia's information is pretty basic and to the point which makes it easy to follow.