What you will learn
- What interchange is
- What an interchange downgrade is
- What dues and assessments are
- What an acquirer’s mark-up is
What you should read first
- The "Credit card basics" article which begins with Issuing banks and cardholders (Part 1 of 6)
This is part 1 of 4 of the fees article. Here are links to each part:
- Interchange (Part 1 of 4)
- Dues and assessments (Part 2 of 4)
- Acquirer's mark-up and pricing methods (Part 3 of 4)
- Introduction to closed loop networks (Part 4 of 4)
This four part article we will break down the fees that merchants are charged for accepting cards from cardholders. Note that these fees are accurate as of December 2014.
There are three categories of fees that a merchant pays on every transaction:
- Dues and assessments
- Acquirer's mark-up
Together, these fees make up what is called the "total cost of acceptance" which is also sometimes referred to as the "merchant discount". The above fee structure is the same for all transactions on Visa, MasterCard, and Discover card networks. Cards issued by American Express are an exception to this rule, they follow a separate fee structure that we will explain later in the article.
- Total cost of acceptance
- The entire cost of the fees that a merchant is charged to accept cards. This is also referred to as the "merchant discount".
Merchants can only control some of these fees but it is very important for them to understand how and why they are calculated to ensure that they are receiving the optimal rate. This article should provide readers with an understanding that will help them navigate the pricing of a merchant account.
"Interchange" is a fee paid to the cardholder's issuing bank. Every time a cardholder transaction is deposited in a merchant's checking or savings account, interchange has been charged. It is calculated as a percentage of the transaction value plus a per transaction fee (e.g. 1.54% + $0.10). For example:
1.54% + $0.10 fee on a $20 transaction:
- 1.54% = $0.308
- + $0.10
- Total interchange cost: $0.408
- A fee paid to the cardholder's issuing bank for every cardholder transaction that is deposited in a merchant's checking or savings account.
The card associations set interchange rates on behalf of their issuing bank members. This means that every issuing bank within a card association charges the same interchange rates. These rates are updated by the card association every April and October and are non-negotiable for a merchant with a few exceptions. These exceptions tend to be very large merchants like Wal-Mart who are able to use their enormous volume of transactions as leverage to negotiate down the standard interchange rates. 
The cost of interchange is mostly based on the risk that a transaction will be fraudulent. This likelihood is determined by the following factors:
- Merchant type
- Entry method
- Card type
- Merchant procedures
In the section below we illustrate the effect that each of these factors has on a merchant’s interchange fee for an example $100 transaction.
Some industries and types of businesses experience more fraud than others. To demonstrate the effect of merchant type, we use a Visa credit transaction at two different merchant types: a supermarket (1) and a car rental agency (2). In both scenarios, the cardholder is using the same card and spending $100.
- Supermarket: 1.22% + $0.05 = $1.27 interchange cost
- Car rental agency: 1.54% + $0.10 = $1.64 interchange cost
Issuing banks and Visa have decided that transactions should be more expensive for car rental agencies than supermarkets because car rental agencies experience more fraud than supermarkets.
The entry method is how a merchant receives a cardholder's information. Here, with a Visa credit transaction at a clothing store, we demonstrate the difference between a $100 transaction at a brick and mortar retail store (1) and a transaction at an online store (2).
- In-store retail: 1.51% + $0.10 = $1.61 interchange cost
- eCommerce: 1.80% + $0.10 = $1.90 interchange cost
The eCommerce (online) transaction is more expensive because online transactions tend to have a higher risk of being fraudulent. This risk is due to the fact that it is easier for a card thief to fraudulently access someone else's card information than it is to duplicate a physical card.
There is a different interchange cost associated with different types of cards. To illustrate the effect of card type we use two in-store retail transactions for $100 using a Visa rewards card (1) compared to a Visa debit card (2).
- Visa rewards card, in-store retail: 1.65% + $0.10 = $1.75 interchange cost
- Visa regulated debit card, in-store retail: 0.05% + $0.22 = $0.27 interchange cost
Rewards cards are more expensive than debit cards partly because issuing banks use the revenue from higher interchange fees on rewards cards to help fund their cardholder rewards programs.
Another factor in the difference in cost is that debit cards almost always have the lowest interchange fees on transactions over $15. This is a result of the Durbin Amendment in the Dodd-Frank Wall Street Reform Act of 2010 which enacted a limit on interchange cost of certain debit cards. The Durbin Amendment stipulates that the maximum interchange fee an issuing bank can receive for debit transactions is a rate of 0.05% + $0.22. If the card was issued by an issuing bank that does not take extra fraud security measures, the issuing bank receives a one cent lower rate of 0.05% + $0.21.
The Durbin Amendment only applies to large banks, those that have more than $10 billion in assets; there is no limit on the interchange fee that a smaller issuing bank can receive. The amendment is an ongoing source of change in the payment industry and we have devoted an entire article to explaining the situation in further detail.
- Durbin Amendment
- An amendment in the Dodd-Frank Wall Street Reform Act of 2010 which enacted a limit on the interchange cost of certain debit cards. It stipulates that all debit transactions where the issuing bank has more than $10B in assets must be regulated at the rate of 0.05% + $0.21 or 0.05% + $0.22 depending on the fraud measures taken by the issuing bank.
Merchant agreements describe very specific requirements for how a merchant must gather and transmit cardholder information. These requirements include stipulations such as the types of information a merchant must gather from a cardholder during a transaction. By gathering such information, merchants decrease the likelihood of fraud occurring.
If the merchant makes a single procedural mistake, however, the interchange rate can be "downgraded" to a more expensive interchange rate. To demonstrate this we use two in-store retail Visa credit transactions, one where all procedures were followed correctly (1), and one where at least one procedure was not met (2).
- In-store retail proper procedures: 1.51% + $0.10 = $1.61 interchange cost
- In-store retail improper procedures: 2.30% + $0.10 = $2.40 interchange cost
Interchange downgrades are the part of interchange cost that a merchant has the most control over and we explain how to prevent such downgrades in a later article.
- Interchange downgrade
- When the interchange rate for a transaction is increased due to a merchant not properly following card association procedures.
What you should read next
- Dues and assessments (Part 2 of 4)
- p. 10 Wal-Mart Stores Inc. v. Visa USA Inc., 14cv5101