As the world moves to a more cashless society, an increasing number of credit and debit card purchases happen every day. The increasing prevalence of these purchase types has led to credit interchange becoming a critical part of the world’s payment processing system.
Interchange allows for financial institutions to exchange money when purchases are made with a credit or debit card. Credit interchange is important to understand — not only does interchange impact consumers, it also represents a significant profit/expense lever for businesses within the global financial system. Today, we’re going to cover the basics of interchange — how it works, what it costs, and who ends up paying these costs.
Who are the key institutions of interchange?
There are four key institutional participants in the credit interchange picture:
- Issuing Banks — Financial institutions that distribute credit and debit cards. Examples of Issuing Banks include Chase and Wells Fargo.
- Merchant or Acquiring Banks — Financial institutions that accept and process card transactions on behalf of merchants.
- Payment Processors — Institutions that submit the transaction information to the fourth and final participant, the Card Network
- Card Networks — Institutions that oversee their credit card brand and route the information to necessary parties. The largest card networks include Visa, Mastercard, American Express, and Discover.
How does interchange work?
First, when a customer makes a purchase with a credit card, the merchant will send card information to the payment terminal/gateway. The terminal will then send that information to the Acquiring Bank; they forward the info to the Payment Processor, who passes on the information to the Card Network. The Card Network checks with the Issuing Bank, which will either approve or deny the transaction. Once the decision is made the Card Network will relay information to the Acquiring Bank and the transaction will be completed. Here is an illustration of the process:
Think of the last time you purchased something at a store — all this accounting happens in a matter of seconds at checkout. This intricate process is essential to modern business; very few people pay in cash now, and card payments make up over 70% of point-of-sale purchases as of 2022.
What is the total interchange fee?
All parties involved in credit interchange want fees from the transaction. Collectively, these fees are considered the Merchant Discount Fee. The fee come in three distinct parts:
- The Processing Fee — A non-negotiable rate which is taken by the card network.
- The Interchange Fee — A non-negotiable rate taken by the Issuing Bank.
- The Acquiring Fee — The only negotiable portion of the merchant discount fee; this is the cut taken by the Payment Processor.
These fees are taken from the merchant’s cut of the purchase and are typically between 1% and 3% of the transaction amount.
To illustrate how interchange works, consider the following: A customer decides to purchase a TV for $400. They swipe their card at a furniture outlet, to pay that $400 ticket price.
When the Consumer swipes, the Acquiring Bank will only send the Merchant $390 (representing a total merchant discount fee of 2.5%). The Consumer’s Issuing Bank will send $392 to the Acquiring Bank, and the Consumer will get billed for the full $400 (with that $8 interchange fee). The Card Network will also take their cut; the Acquiring Bank will send the network, in this example, $0.25. The Payment Processor keeps $1.75 for their part in the system. In summary:
- Consumer pays $400
- Merchant receives $390
- Issuing Bank makes $8
- Card Network makes $0.25
- Payment Processor makes $1.75
That $400 from the consumer went through quite a journey! Accumulated across many transactions, interchange represents a significant cost to merchants. Most merchants accept this increased cost due to the corresponding increase in sales that comes from accepting credit card payments. In some cases, merchants will make the customer pay for some of the fee through offsetting charges like a “payment processing fee”, allowing them to recoup some of the lost value from card payments. Merchants rarely pass the entirety of the cost on to consumers, but it is a real consideration for tight-margin businesses where 1–2% represents the difference between staying solvent or going out of business.
What determines interchange rate?
Although non-negotiable, interchange rates are not equivalent across the board and are distinct for different types of transactions. The differentiation is determined based on cost to the issuing bank and risk of fraud. In a nutshell, interchange rate can differ in the following circumstances:
- Debit cards have lower interchange rates than credit cards
- Premium rewards credit cards have higher interchange rates than standard credit cards
- In-person transactions have lower interchange rates than online transactions
- Type of business will qualify merchants for different interchange rates
Aside from encouraging customers to pay with cash or with debit card, merchants have minimal leverage to control the cost of interchange rates if the merchant decides to broadly accept credit card payments.
How much can interchange differ?
For a merchant to accept credit card payments, they must sign up for a card processing service. This is the processing fee, which is negotiable and typically comes in four main pricing structures:
- Flat-Rate Pricing — Merchants are charged one flat-rate processing fee no matter the type of transaction. An example of this is a total merchant processing fee of 2.6% + $0.10 per swipe. This pricing is best for small businesses because the pricing is simple.
- Interchange-Plus — This pricing is very transparent and separates interchange fees and processor markups. An example of this is “Interchange + 0.2% + $0.10 per swipe”. The “plus” part and the processor markup is the “0.2% + $0.10 per swipe”. This method is best for growing businesses and creates consistent processor fees.
- Subscription Pricing — This method also separates markup from interchange rates, but the markup is a small fixed per-transaction fee. On top of that, the merchant will pay a subscription fee for the service. An example of this is “interchange + $0.05 per swipe, plus a $590 monthly subscription”. This is best for large businesses because of the lower markup per swipe.
- Tiered Pricing — Instead of many different interchange rates, this method has three flat rates depending on the type of card used in the transaction. This is not generally recommended for any merchant, because the markup tends to be significantly more opaque. In general, we have found that tiered pricing often generates higher processing fees.
How can merchants lower their interchange fee?
Due to the cost of interchange, many merchants will try to get out of paying the full-freight fee with either a credit card surcharge or a cash discount. Credit card surcharging passes the cost of credit card processing to the customer by adding a fee on top of the retail price. However, there are strict guidelines around surcharging. The final customer surcharge cannot exceed the actual processing fee the merchants are paying (or 4%, whichever is lower). The surcharge must also be clearly communicated to the customer. Cash discounts are a more customer-friendly alternative which offers a discount to customers who pay in cash rather than credit card.
Prior to 2010, there were also a critical mass of businesses that did not accept credit cards processed by certain card networks — in particular, high rewards card from American Express or more niche networks like Discover were occasionally excluded from the approved network list by certain restaurants to avoid paying their slightly higher merchant discount fee. This practice is considerably rarer today, but still present in many off-the-beaten path areas within the United States that are utilizing older technology, like some of Idaho and Montana’s outlying counties. It also can be true of tiny local businesses that lack sufficient customer volume to justify the higher interchange rate some processors charge — there’s likely a few tiny, hole-in-the-wall restaurants in your neighborhood that don’t take AmEx and now you know why!
Why is interchange important?
Interchange represents a vital pressure point in the entire financial system. It not only impacts merchant cost, but also the end price a consumer pays and an important fiscal lever for financial institutions. Interchange fees affect the prices you pay for the goods you buy, and high transaction periods can increase or decrease net profits for credit card issuers regardless of the interest rate charged on the standing balance of their users.
Interchange also impacts rewards structures, as the interchange fees for better rewards cards are often higher to account for the cost of the programs. In addition, issuing banks have different minimum interchange rates, which is why certain merchants will only accept cards from certain issuers (i.e., Mastercard only). It is our hope that this primer on interchange was informative to you, whether you’re a merchant that pays it, a bank employee that processes it, or a consumer who occasionally pays an extra few dollars on a surcharge fee.