What is an Interchange Fee and How Are They Calculated?
Modern financial transactions look simple from a consumer standpoint. However, there's more behind the scenes than most realize, and businesses must foot the bill for several complex processes to make transactions possible. We live in an increasingly cashless world. While some still rely on cash here and there, most consumers rely on card payments for most purchases.
It's not hard to see why. Card payments are quicker and more convenient. But from a business perspective, they can be more costly. Convenience doesn't come cheap, and businesses that accept credit or debit card payments must pay to support the complex financial infrastructure we have today.
Interchange fees are one of the ways they do that. An interchange fee, also known as swipe fees or interchange reimbursement fees, is one of the costs of accepting payment cards for transactions. They incur with all card transactions, but the amount businesses pay will vary due to numerous factors.
To understand the total cost of doing business and performing debit and credit card transactions, you must understand how interchange fees work and how to calculate them. In this comprehensive guide, you'll learn all that and more.
A Quick Overview
An interchange fee is a transaction fee charged between banks. It covers the cost of processing debit and credit card payments. Whether you're a small business owner or the leader of a larger enterprise, these fees apply to all card transactions.
Despite how quick and simple card transactions seem, moving money and authorizing transactions is a complex process. There are three parties involved with interchange fees. They include:
• Card Networks: Card networks, also known as card schemes, facilitate transactions. Every card payment occurs on a card network, and they're the ones that set interchange fees. Examples of card networks include Visa, Mastercard, American Express, etc.
• Issuers: Issuers refer to the cardholder's bank. A cardholder would be the customer. The issuer is the bank, financial institute or credit provider that supplied the card.
• Acquirers: Acquirers, called acquiring banks, process payments for merchants. They're part of the entire package provided by merchant service providers.
When a small business owner accepts payment and uses a gateway to initiate a transaction, these three parties play some role in the process. Transactions occur on the card network, using the network infrastructure to exchange information.
The acquiring bank is responsible for submitting payment details and requesting authorization for the transaction from the card issuer. Once authorized, the acquiring bank can retrieve funds and move them into the business merchant account.
So, where does the interchange fee come into the mix? The merchant's acquiring bank will pay the interchange fee to the cardholder's bank. Then, the merchant must repay the interchange fee to the acquiring bank.
Businesses pay merchant service providers to handle the logistics and process transactions. It's an important service that makes modern payments and payouts possible.
Each card transaction comes with interchange fees. Generally, the repayment of the interchange fee to the acquiring bank is part of the processing fees charged by merchant service providers.
Interchange fees are invisible to consumers but affect small business owners and enterprises. These fees serve a few different purposes.
One of the most important reasons interchange fees exist is to maintain and support card networks. Fees help fund fraud prevention measures, support infrastructure maintenance, and more.
Interchange fees can also help cover acquiring bank costs, provide compensation to card issuers, and incentivize issuing banks to push card payments. They even help fund things like card rewards and benefits.
Factors that Influence Rates
Interchange fees can vary from transaction to transaction. In the United States, they can be around 3 percent of the transaction amount. It all depends on several factors.
• Card Network: The card scheme has the biggest impact on interchange rates. As mentioned earlier, the card network is responsible for setting the interchange fee. Therefore, the cost may differ between a transaction performed on the Visa network and one on the Mastercard network.
• Debit or Credit: Card networks may also set different fees based on the type of card used. For example, interchange fees differ between the Visa credit card network and the Visa debit card network.
These differences exist because credit card companies carry a higher level of risk. With debit or prepaid debit cards, the money is already there.
• Merchant Category Code: The merchant category code (MCC) is a four-digit code that networks use to classify merchants based on the goods or services they provide. Card schemes charge varying interchange fees based on the MCC. For instance, charities and utility service providers often have lower costs than other merchants in the United States.
• Card Presence: Whether or not the card is present during the transaction can also impact the interchange fee. Card-present (CP) transactions are those you see in stores and supermarkets. They come with lower interchange fees because the presence of the card means there's a lower risk of fraud.
Conversely, card-not-present (CNP) transactions usually occur with online retailers, resulting in a higher risk of fraud.
• Regionality: Transaction regionality refers to how local the transaction is for the consumer. In the United States, transactions between domestic banks typically come with a lower interchange fee than those across borders.
• Card Types: The type of cards used can also impact interchange fees. Commercial cards, like those used by business owners and tied to a corporate account, may have higher costs than a standard consumer account.
Interchange fees may also be higher when the consumer uses a rewards card. The higher fee helps cover the cost of the perks provided by the issuer.
A Breakdown of the Fee Structure
Interchange fees aren't static. As you can see from above, many factors can influence how much businesses will pay for card payments. Because there are so many variables, it can be challenging to determine a precise amount with each transaction. That's why merchant service providers typically include the interchange fees as part of the umbrella of “processing fees.”
The easiest way to look at interchange fees is to break down the fee structure. Three core fees are involved, and they all involve the three parties making transactions possible.
• Assessment fees
The first component of interchange fees is the assessment. Assessments change the percentage of the transaction charged to businesses. For example, total interchange fees are often 2 to 3 percent in the United States. They can be as little as 0.3 percent of the total transaction amount in other parts of the world.
Assessments cover all the factors we mentioned earlier. Details like the merchant category code, regionality, card presence, and more will determine the overall assessment and create the core percentage amount charged as the interchange fee.
Interchange fees may also include an acquiring bank markup. This markup may be part of the agreement signed with a merchant service provider, and it covers the cost of acquiring funds from the cardholder's issuing financial institution.
• Network fees
The network fee goes to the network, such as Visa, Mastercard, American Express, etc. This part of the interchange goes to the card scheme, and it's the price of using the network to facilitate the transaction.
Networks set the interchange fee, and the structure is complex. Using the above-mentioned factors and market conditions, it can vary between card schemes. Networks can also change interchange fees. Each network publishes its interchange rates twice yearly, in October and April.
• Issuer fees
Finally, there's the issuer fee. This part of the interchange fee structure goes directly to a consumer's card issuer. Some variable factors, such as the type of card the consumer uses and existing rewards programs, may increase the issuer fees.
• Regulation and Reform
In the past, interchange fees were notoriously complex. Some even argued that they were unfair. Large businesses with higher transaction volume often negotiated lower fees because there was little transparency in how interchange fees worked. Meanwhile, smaller business owners didn't receive that luxury.
New regulations and reform helped change that. Efforts to standardize interchange fees helped level the playing field and create more transparency for businesses.
Regulations vary, but in the United States, The Durbin Amendment created fee caps for debit and prepaid debit transactions. The cap depends on the issuing bank's assets and fraud prevention policies.
The Relationship With Merchant Discount Rates
It's impossible to avoid interchange fees entirely. They're the cost of doing business and accepting card payments. The convenience that debit and credit cards provide comes with costs, and companies must pay interchange fees to cater to the growing numbers of consumers who don't want to deal with cash dollars and cents.
However, companies may save on costs by choosing a merchant service provider with a fee structure that is appropriate for their business.
Some merchant service providers use the Interchange++ pricing model. With this pricing model, businesses pay the interchange fee charged by issuers, and payment processors show a detailed breakdown of the fee structure.
Others will use a tiered pricing model, grouping transactions into tiers based on transaction type, sale category, card type, etc. Then, merchants can pay set fees for each tier.
Many merchant service providers offer a blended pricing model. With this model, businesses pay an average payment processing cost plus a fixed markup. For example, providers may give you a set percentage plus a small fixed fee for all transactions. While less transparent, it often makes things easier to understand.
Examples
Interchange fees can be confusing; what businesses pay depends on many factors. However, having a general understanding of them is crucial for modern companies.
Many businesses, like small merchants and corner stores, limit card payment transactions to a certain size. For example, you might see signs saying merchants don't accept cards for transactions under $10.
There's an important reason for that! Say, for example, that a consumer tries to use a card to pay for a $1 drink. If the merchant pays a fixed interchange fee of 40 cents, the profit margins will be so low that they will lose money performing that transactions.
But what about larger transactions? How do interchange fees work there? How you calculate interchange fees depends on the pricing model used. But for simplicity, let's say that a customer purchases a vacation package for $1,000 using their Visa credit card.
After assessments and acquiring bank fees, the interchange fee might be 2.25 percent of the transaction. However, because the customer uses a card with rewards, the issuer charges an additional 10 cents.
The total interchange fee that the merchant must pay would be $25.10.
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