Interchange fees explained

Interchange fees are transaction fees that merchants must pay the card-issuing banks whenever customers use credit or debit cards to make purchases from their stores.

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November 21, 2023
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Interchange fees explained

Understanding the cost of a transaction is a key metric for any merchant. Different payment methods attract different costs. For card payments, one of the most significant is known as the 'interchange fee'. Yet, many merchants don't have a clear view of what it is or how much it costs them. That makes it harder for them to manage the cost more effectively, which in turn hurts their profit margins.

What are interchange fees?

Interchange fees are transaction fees that merchants must pay the card-issuing banks whenever customers use credit or debit cards to make purchases from their stores. Interchange fees cover:

  • handling costs
  • fraud
  • the costs of bad debts
  • as well as the risk involved in approving the payments

All issuing banks expose themselves to risks when they give credit cards to consumers; however, they offset those risks by charging the merchants that accept their cards.

Let's remind ourselves of what happens when a card payment takes place. The merchant's bank (the acquirer) sends a payment request to the customer's bank (the issuer) via the card network. The issuing bank then performs a number of checks to determine whether to accept or reject the request, mainly to ensure that the card isn't being used fraudulently and that the customer has the necessary funds or credit in their account.

The issuing bank then deposits the money with the acquiring bank—or sends a rejection notice. Though all this happens in the blink of an eye, it's a complex process for which the issuing bank gets paid. This is known as the interchange fee.

In theory, the interchange fee is charged by the card scheme to the acquiring bank. However, the card operator passes this fee to issuing banks as an incentive for the banks to offer and promote their card over others. That's why most people understand the interchange fee as taking place between the issuing bank and acquiring bank.

In practice, the issuing bank withholds the value of the interchange fee, and the acquiring bank simply passes this balance through when they deposit the funds in the merchant's account. So, in the end, it's the merchant that foots the bill.

How do interchange fees work?

Interchange fees come into play every time a consumer makes a purchase using their credit card, and cover the costs of processing and authorizing the transaction. Depending on which pricing model you’re on, you may be able to see the interchange fee itemized as a percentage of the transaction cost, or it may be bundled in with other processing fees.  

There is no set rate, but, on average, interchange fees account for between 0.3% and 2% of the total transaction cost and between 70% and 90% of all fees that merchants pay to banks. While most of this fee goes to the card issuing bank, a small percentage also goes towards the party that processes the payment.  

Additionally, interchange fees are not static, and are frequently adjusted by banks and card networks to account for changes in transfer costs, interest rates, and relative risk. Visa and Mastercard change their rates every April and October.

Interchange fee example

Let’s say you’re an online merchant based in the US that sells electronic goods. A US customer decides to buy a TV from your website for $500. They enter their credit card details, which are captured and submitted by the processor to the issuing bank and card network. 

The payment is accepted, and the issuing bank transfers the $500 to the acquirer, minus the interchange fee. For this example, the customer’s card is a Visa Rewards Signature, which has an interchange rate of 2.1% + $0.10. That means the amount transferred would be $489.4. The acquirer then settles the final sum in the merchant’s business bank account.

How are interchange fees calculated?

Though the interchange fee is 'paid' to the issuing bank, the rate is set by the card networks. The interchange fee is made up of a percentage of the transaction value plus a fixed fee. There is no standard rate.

Instead, interchange fees vary by a range of criteria, including:

Card schemes

Card schemes (card networks) process payments using debit and credit cards. They manage payment transactions according to rules that allow consumers to use their cards with third parties, such as retailers.

The issuing bank and the acquiring bank must be members of the same network as the card in order for the payment to be made. Card networks include American Express, Mastercard, UnionPay, and Visa. Since card schemes charge different interchange fees, the cost for a consumer paying with a Mastercard isn't the same as for a consumer paying with a Visa.

Credit card vs. debit card

Typically, interchange fees for credit cards are higher than for debit cards because it's easier and safer to approve debit card transactions. The reason: funds for debit card transactions come directly out of customers' linked bank accounts and it's easy to confirm that there are sufficient funds in those accounts to cover the costs of those transactions.

Reward cards

Issuing banks also offer rewards cards that include a variety of benefits, such as cash back on purchases or frequent flier miles; the interchange fees are generally higher for rewards cards as the increased fees pay for the extras offered by rewards programs. Rewards cards have a particularly negative effect on merchants on tiered pricing plans.

Card present vs. card not present

Interchange fees for card-not-present transactions, i.e., online as well as telephone and mail order transactions, are significantly higher than those for card present, i.e., in-person transactions, as the risk of fraud is lower when merchants are able to see consumers' cards. Generally, the total processing rate that a merchant services provider charges will include the added costs of processing these payments.

Merchant category code

The payments industry uses four-digit merchant category codes (MCCs) to classify businesses based on the types of goods or services they sell. Credit card associations use MCCs to categorize interchange fees based on business categories, e.g., florists, restaurants, hardware stores, online marketplaces, etc. An organization's assigned MCC can have an impact on its interchange fees, as higher risk businesses, such as airlines, typically have higher interchange fees. Merchants can find the current rates by checking the card schemes' websites.

Security protocols used

The more secure transactions are, the lower the interchange fees. In the U.S., the Address Verification Service as well as card security codes are the most used fraud prevention tools. However, as fraud related to card-not-present transactions continues to increase, major credit card processors are developing new tools to mimimize the risk of fraud, such as tokenization. In April 2022, the major credit associations began charging lower rates to merchants using tokenization and higher rates to merchants not using it.

Country of transaction

Interchange fees vary depending on the country where the transactions occur. Interchange fees in European countries are lower than in North America. A European regulation limits interchange fees for consumer credit cards to 0.3% of the transaction's value and consumer debit cards to 0.2%. The regulation ensures that interchange fees are capped at a level such that retailers' average costs are not higher for card than for cash payments.

Where the card was issued

If the acquiring bank and the issuing bank are in different countries or jurisdictions, a higher interchange fee will reflect the additional complexity of the payment process.

The volume of transactions is also considered, with big merchants expecting to negotiate lower interchange fees. In other words, merchant interchange fees can vary and depend on what is being sold, where, how, by whom, and to whom. The overall interchange fee for each transaction is technically made up of hundreds of "mini" fees, which can lead to transparency issues when it comes to cost.

Who pays interchange fees?

This is a more complicated question than it might first appear. As described earlier, interchange fees are set by card networks and charged by the issuing bank to the acquiring bank, which passes the cost onto the merchant. 

However, there is another factor to consider. In 46 of 50 US states, merchants are allowed to apply surcharges to credit card payments covering up to 3% of the transaction cost. That means, as long as you give your acquirer 30 days notice that you’re planning to surcharge, you can pass the cost of interchange fees onto your customers. 

In the UK and the EU, surcharging is banned for most credit and debit card transactions, so merchants based or trading in these regions still have to pay the interchange fee.

What is interchange++ pricing?

Interchange++ pricing is a type of pricing available for payments. Interchange++ pricing provides more transparency than other pricing types as it shows merchants detailed breakdowns of their costs. Interchange ++ pricing comprises two elements: the first plus, which is the acquirer's fee, and the second plus, which is the card scheme fee. Typically, card scheme fees, which are determined by such factors as card and transaction types, are significantly lower than interchange fees.

Larger merchants tend to use interchange++ pricing because it offers total transparency into what the fees are for every transaction. If, for example, a merchant observes that many of its buyers use debit cards, which are charged a lower interchange fee than credit cards, the retailer can tweak its marketing to urge shoppers to use that specific method of payment.

48% of merchants do not receive a detailed breakdown of their payment costs from their payment service providers. Switching to a provider that offers Interchange++ pricing can help merchants solve this issue by giving them more transparency into the fees they pay.

Interchange++ pricing vs. blended pricing

Another type of pricing that payment processors offer is blended or standard pricing, which bundles all the costs of processing transactions into a single fee known as the Merchant Service Charge. That means payment processors blend interchange fees, scheme fees, and markup fees together and present them to merchants as one fixed percentage.

An advantage of blended pricing is that it's easier for merchants to understand and plan for because fewer variables are involved. However, blended pricing is less transparent, making it easier for acquiring banks to conflate fees so they can earn more profit.

With a blended pricing model, merchants are charged a gateway fee, which is a fixed cost per transaction and a variable fee. The variable fee encompasses the interchange cost, the scheme cost, and the acquirer's mark up. Merchants are however unable to see the split.

On the other hand, Interchange++ gives merchants more transparency over the fees they're being charged, enabling them to clearly understand the margin/profit the payment service provider makes. But because Interchange++ is a passthrough model, it is subject to cost fluctuations.

Interchange fees regulation

In recent years, interchange fees have become heavily regulated by governments, with standardization, fee caps, and greater transparency introduced to protect merchants. 

In the US, the Durbin Amendment (enacted in 2010) caps interchange fees for debit and prepaid transactions at 0.05% of the transaction + $0.21. This cap does not apply to credit cards. 

In the European Economic Area (EEA), since 2015, interchange fees for all consumers card payments are capped at 0.20% for debit cards and 0.30% for credit cards. The only exception is for interregional card-not-present transactions, which are capped at 1.15% for debit cards and 1.50% for credit cards.

What pricing model does offer? uses the transparent interchange++ pricing model, billing transactions individually so that there are no hidden or additional costs.

Interchange fees may be inescapable, but how much merchants pay is not. Seemingly small percentage fees add up quickly and can become a drag on growth, especially for smaller merchants with tighter margins. For larger companies, ignorance of merchant interchange fees can mean millions in avoidable costs. But as we've seen with other aspects of payments, the innovative merchants will view interchange fees not just as a way to save money, but they'll also use the enhanced transparency and insights from interchange++ as an opportunity to make far-reaching and smarter data-driven decisions.

Visit our payment processing product page or get in touch to learn more about Checkout's products and pricing.

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November 21, 2023 10:47
November 21, 2023 10:47