Interchange, in the context of banking, payments, card processing, and cards, refers to the fee typically paid by a merchant’s bank (acquirer) to a customer’s bank (issuer) for card-based transactions. This fee is a key component in the financial operations of credit and debit card networks.
Official Definition and How It Works
The interchange fee is a transaction fee set by card networks (like Visa, MasterCard) that the merchant’s bank pays to the cardholder’s bank whenever a customer uses a card for a purchase. The fee compensates the issuer for the risk and cost involved in handling card payments, including fraud prevention and providing credit.
Who Offers It?
Interchange fees are set by card networks (e.g., Visa, MasterCard) and vary based on the type of card (debit, credit, rewards), the transaction type, and the merchant’s industry.
Importance and Beneficiaries
Interchange fees are crucial for the functioning of the card payment ecosystem. They incentivize banks to issue cards and participate in the network. The primary beneficiaries are the card-issuing banks, as they receive the interchange fee income.
Expense or Income?
Interchange is an expense for the merchant and their bank, as they pay the fee. It’s an income for the card-issuing bank.
How It Works Between Two Banks
- Customer Purchase: A customer uses a debit or credit card to make a purchase.
- Bank Communication: The merchant’s bank requests authorization from the customer’s bank.
- Approval and Transfer: Once approved, the transaction is processed, and funds, minus the interchange fee, are transferred from the issuer to the acquirer.
- Settlement: The merchant receives the payment, less the interchange fee and any additional merchant service charges.
Benefits for Program Managers and Card Promoters
Program managers or card promoters can benefit from interchange by:
- Offering competitive rates to attract merchants.
- Negotiating better terms with card networks.
- Providing value-added services to merchants, leveraging interchange income.
Examples
Debit Card Transaction:
- A customer buys groceries using a debit card.
- The grocery store’s bank pays an interchange fee to the customer’s bank.
- The fee is lower than for credit transactions, reflecting the lower risk of debit cards.
Credit Card Transaction:
- A customer purchases electronics with a credit card.
- The electronics store’s bank pays a higher interchange fee to the customer’s bank, given the higher risk and benefit of credit transactions.
Rewards Card Transaction:
- A customer uses a rewards credit card at a restaurant.
- The restaurant’s bank pays an interchange fee, part of which funds the rewards program.
- The fee is typically higher due to the added value of rewards.
Let’s go through a calculation for an interchange transaction. I’ll use a hypothetical scenario with a credit card transaction at a retail store to illustrate how the interchange fee is calculated and distributed.
Scenario
- Transaction Amount: $100
- Interchange Rate: 2% (This rate varies based on card type, merchant category, and other factors. For this example, we’ll use a simple flat rate).
Calculation
- Total Transaction: The customer makes a purchase of $100 using their credit card.
- Interchange Fee Calculation: The interchange fee is calculated as a percentage of the total transaction amount.
- Interchange Fee = Transaction Amount x Interchange Rate
- Interchange Fee = $100 x 2% = $2
Distribution of Payment:
- The merchant’s bank (acquirer) will pay the $2 interchange fee to the card-issuing bank (issuer).
- The merchant receives the transaction amount minus the interchange fee. Therefore, the merchant gets $100 – $2 = $98.
Flow of Funds
- Customer’s Bank (Issuer): Receives $2 as the interchange fee.
- Merchant’s Bank (Acquirer): Pays out $100 initially, then gets reimbursed $2 from the issuer, effectively paying $98.
- Merchant: Receives $98 from their bank after the interchange fee has been deducted.
Impact
- For the Merchant: This fee is part of the cost of accepting credit cards. Merchants might factor this cost into their pricing strategies.
- For the Customer: The customer pays $100; they are typically unaffected directly by the interchange fee.
- For the Banks: The issuer benefits from the interchange fee, while the acquirer facilitates the transaction and ensures the merchant is paid.
This example simplifies the process for clarity. In real-world scenarios, additional fees like assessment fees by the card network and processing fees by the merchant’s bank might also apply.
Conclusion
Interchange fees are a fundamental aspect of the card payment system, balancing the interests of various parties involved. Understanding these dynamics is crucial for anyone dealing with card-based transactions, be it from a merchant, bank, or consumer perspective.
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This page was last updated on December 21, 2023.
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