What is a payment processor? (And how does it work?)

Payment processors are essential for card payments and eCommerce.

Understanding what a payments processor is can help you better navigate the complexities of the payments process more generally. This in turn will help you keep ahead of the curve in today's fast-changing eCommerce and payments processing world.

Let's look closer at what payments processors are, how they work, and what role they play in the payments process.

What is a payment processor?

A payment processor offers the technology to manages the card transaction process. It acts as a facilitator between the main financial institutions involved the payments process.

It authorizes credit card transactions and ensures merchants get paid on time. It does this by facilitating the transfer and settlement of funds.

Some payment processing services also provide equipment for card acceptance, security solutions, implementation of PCI compliance, customer support, and other value-added services.

Do businesses need payment processors?

Businesses need some form of payment processor if they want to accept card, digital, mobile, or ACH payments. This applies to both eCommerce and brick-and-mortar stores.

How does a payment processor typically work?

Online payments typically involve at least two financial institutions, including:

• The issuing bank (the customer’s bank)
• The acquiring bank (the merchant’s bank)

Payment processors facilitate the connection and communication between these financial institutions.

This typically takes place during the following process.

1. Transaction is initiated

Electronic payment processing appears to happen in an instant for customers. But using a card reader device at point of sale (POS), or pressing 'pay' on an online checkout page, is actually initiation of a transaction.

Cardholders are passing on their payment information (typically card details and name) and submitting a request.

2. Verification & encryption

The physical (or online) terminal passes the payment information onto the payment gateway, which verifies and then encrypts the payment information.

3. Enter the payment processor

Next, the payment gateway passes on the information to the payment processor. And the payment processor transfers the information to the card network, e.g., Visa or Mastercard.

4. Authorization/disapproval

The card network authorizes or declines the transaction, then informs the payment processor via the card network.

5. Confirmation

Once the merchant and the customer have been notified of the outcome of the payment authorization it appears that the transaction flow has now completed. However, there is still one last stage.

6. Settlement

Settlement refers to the final transfer of funds between accounts.

Once transactions that have been authorized, the payment processor instructs the issuing bank to settle with the merchant account. This sometimes happens immediately, other times within a few business days.

What is a merchant account?

A merchant account is a specific type of account that allows businesses to accept credit and debit card payments from customers. It is what establishes a business relationship between a merchant and the acquirer.

A company does not necessarily need to have its own merchant account. It can use an aggregate account which is shared between multiple merchants. In this case, the company will need to contract with a third-party payment processor.

What's the difference between a business account and a merchant account?

Whilst merchant accounts and business accounts can be provided by the same banks, they are not the same thing. A business account is used for everyday expenditures and financial tracking. But a merchant account is used for receiving payments and securely handling payment data.

Types of payment processor set up

Many merchants do not choose a specific payment processor. Instead, they open a merchant account, and use the payment processor that comes with it.

Third-party payment processors

Third-party payment processors like PayPal, Stripe and Square are providers that do not require a separate merchant account to accept card and mobile payments.

They are usually quick and simple to set up, and better suited to small-businesses.

They work by having issuing banks deposit funds into aggregate accounts, which are shared between different merchants. Many companies share this aggregate account - sometimes thousands, which can speak to the account's reliability.

Once the funds have been deposited, the processor deducts its processing fees and transfers the remaining funds to each business’ bank account.

However, this transfer can take a few business days, which is longer than it takes for merchant accounts.

How to choose a third-party payment processor

1. Payment methods

Many companies need to be able to accept different payment methods, including credit or debit cards, digital wallets and bank transfers. So, they need a third-party payment processor that can support these.

2. Payment security

When choosing a third-party payment processor, the company should make sure the processor is PCI-PDI compliant and has fraud prevention baked in. It should also use encryption and other security measures that are necessary to protect the customer’s payment details.

3. Compatibility

The third-party payment processor must also be compatible with the other e-commerce software the company uses, such as payment gateways.

4. Costs

The cost of payment processors varies according which specific provider provides which type of payment processor.

Payment processing fee structures associated with merchant accounts are relatively fixed. They typically include start-up fees, transaction fees, chargeback fees, and credit card processing equipment lease charges.

Different third-party payment processor providers have different fee structures. They can include an initial start-up fee, a monthly membership fee, and a flat-rate processing fee or a percentage of the transaction value. And there may sometimes be hidden costs, such as chargeback termination fees.

5. Reviews

Companies should check reviews and testimonials before choosing a third-party payment processor. These will hopefully give insight into all of the above points as well as costs, customer service, etc.

What's the difference between a payment gateway and a payment processor

The main difference between a payment getaway and payment processor is that the former ensures the safe transfer of customer information into the payment chain, while the latter is responsible for the actual transfer of funds.

Is PayPal a payment processor or a payment gateway?

PayPal is third-party payment service provider (PSP) that does not require a merchant account.

It is not fully a payment processor. But it is closer to a processor than it is to a payment gateway.

In 2013, PayPal acquired Braintree. This operates as a separate eCommerce payment processing service and payment gateway that integrates with PayPal.

Conclusion

Payment processors are essential technology that securely orchestrate card transaction processes between merchants and their cardholders.

They are used for brick-and-mortar stores that want to accept card payments in-store and e-commerce platforms that want to accept payments online. This includes multiple electronic payment methods, such as cards, mobile or online payment.

They act as intermediaries that facilitate secure authorizations and transaction settlements. They establish a bridge between acquirers, issuers, and card networks.

Payment processors often also offer valuable-added services such as equipment provision, security solutions, PCI compliance support, and customer assistance.

Small merchants do not usually choose a payment processor directly. Instead, they use their merchant bank's payment processor by default.

But without a merchant account, businesses that want to accept card or mobile payments from their customers have no other option but to work with third-party payment processors. And larger companies that deal in bigger volumes of transactions often create a more bespoke

These processors, whether traditional or third-party, offer distinct fee structures and services tailored to different business scales.

Payment processors are different to payment gateways. The former oversees fund transfers, while the latter ensure data security.

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