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.

In this article, we'll be going back to basics, explaining:

• What the interchange fee is
• How merchants can get more visibility over interchange fees
• How to reduce interchange fees

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 much is the interchange fee?

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.

In Australia, the cap for debit and prepaid fixed interchange has been reduced from $0.15 to $0.10 as of February 1, 2022, while the cap remains at 0.20% for debit and prepaid interchange rates that are percentage-based.

There's no cap on interchange fees for credit card payments in the U.S.; however, the Durbin Amendment caps interchange fees on debit card payments at $0.22 per transaction and five basis points multiplied by the value of the transaction - only where the card is issued by banks with over $10 billion in assets.

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.

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.

The following are the pros and cons of using a blending pricing model:

Pros:

• Simplicity - As the name implies, blended pricing combines all processing costs into a single price. You will not have any transparency into the actual hard costs you accrued but can safely estimate what you will have to pay in transaction costs for a given level of sales.
• Offset High Interchange Rates - Blended rates can be a good fit if your products have a high average ticket value and have a large percentage of Amex and rewards card sales. These conditions can often create higher interchange rates, so a blended cost may end up cheaper than the transaction cost, in which case the provider can raise the blended rate.
• Good for smaller businesses - If you don't have the time and resources to investigate and reconcile credit card processing and interchange rates, blended rates provide a simple and easy solution while you get your business up and running, allowing you to focus your attention on other parts of your operation.

Cons:

• No transparency into transaction fees - Typical consumer credit card interchange rates average 1.83% while debit card interchange rates can range from 0.05%-0.60%. If a small percentage of a merchant's customers are using debit cards, the payment processor can be making anywhere from 1%-2% per transaction of the 2.9% rate that the merchant is being charged, for instance.
• Limited flexibility on pricing - Companies that offer blended pricing may start with a standard price per transaction. Then, to obtain enterprise rates, they will have to achieve a much higher sales volume with minimum online monthly sales.
• Hidden fees - There can often be hidden monthly gateway fees, set-up costs, or PCI compliance fees that are buried in contracts.

Here are some pros and cons of using the interchange++ pricing model:

Pros:

• Complete transparency into transaction fees - Merchants know exactly who is making what on every transaction running through their platforms.
• Lower total transaction rates - With average interchange rates for credit cards of 1.81%, average card association rates of 0.11%, and average processor/gateway fees of 0.10%-0.40% + $0.20, a merchant's total transaction rate for a consumer credit card would come out to 2.02%-2.32% + $0.20 per transaction versus the typical blended rate of 2.9% + $0.30. The difference can amount to huge cost savings over time, especially for large and enterprise businesses.
• Flexible pricing - Companies offering merchants Interchange++ pricing are often willing to work with merchants to tailor pricing to their specific needs. They are often willing to negotiate the 0.10%-0.40% processor fee if a merchant sells an expensive item or lower the $0.20 per transaction fee if a merchant's product is relatively cheaper to reduce the merchant's all-in rate.

Cons:

• High interchange rates - American Express and status cards can have interchange rates that average above 2.0% consistently. If a merchant sells a product with a high average ticket value, consumers are more likely to use their Amex or rewards cards where the interchange rates are above 2.0%.
• Varying rates per transaction - With different interchange and card association fees for each transaction, the total processing fee rate for every purchase will be different.

What pricing model does Checkout.com offer?

Checkout.com uses the transparent interchange++ pricing model, billing transactions individually so that there are no hidden or additional costs.

After working with another international payments provider that offered the blended pricing model, Buycycle, a marketplace that allows people to buy and sell used bicycles, turned to Checkout.com because it wanted to understand what it was paying for.

Although Buycycle's founders thought that its payment fees were very high, there wasn't much they could do about it since their payments provider used the blended pricing model so the team wasn't able to determine exactly where the charges came from. However, since working with Checkout.com, which uses interchange++, Buycycle has gained complete transparency into its transaction fees.

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.