Do you accept and process debit and credit card payments? If so, your business needs to understand how payment processing works, who is involved, and how long it takes. This article will discuss the differences between payment authorization and settlement to illustrate this two-stage process involving multiple parties.
Credit Card Processing
Did you know that today’s customers use non-cash payment methods for 74 percent of transactions? A 2020 Federal Reserve study found that 29 percent of all transactions are from credit cards, a number that will continue to increase due to the convenience and reliability of digital money. While you likely know how popular card payments are, you may not be familiar with how card payments are authorized and settled. Indeed, these steps are necessary to receive payment from your customers in exchange for the products and services they purchase with a debit or credit card.
Payment authorization is when the merchant submits a transaction request to the issuing bank (cardholder’s bank), who will determine if the transaction should be approved or denied. The issuing bank will decide after verifying that the cardholder has the appropriate funds or credit in their account. After an authorization request has been sent, the merchant will receive a response code from the card association. These authorization response codes typically contain two digits (like 00) or a letter and number (N1). Indeed, there are over 50 different codes, which are different for each card association, payment processor, or gateway. While there are various codes, the issuer will recommend merchants do one of two things – approve or decline the pending transaction.
Common Reasons for Denied Transactions
An issuing bank may recommend that a merchant decline a transaction for various reasons.
- The cardholder’s account lacks sufficient funds or credit to make a purchase.
- The cardholder reports that their card is lost or stolen, therefore it’s a fraudulent transaction.
- Key cardholder details were not entered correctly or at all, such as security codes.
- The payment processing technology is malfunctioning, so the issuing bank cannot send an accurate, timely response.
While these are just a few scenarios, the critical point is that merchants should only settle transactions that have received an approved response code. If merchants receive any other code, it’s a good idea to decline the transaction and request the customer to use a different form of payment, such as cash, check, or a different card. It is possible to re-authorize the same card within 12 hours of the first attempt, making the transaction eligible for a declined authorization chargeback.
For a transaction to be approved, two requirements need to be fulfilled. The cardholder’s account must have enough money or available credit to pay for the products or services. The card also must not be reported as lost or stolen, which would indicate card fraud.
Once a transaction has been approved, settlement is the second and final step. This is when the issuing bank transfers the funds from the cardholder’s account to the payment processor, who then transfers the money to the acquiring bank. The business will then receive the authorized funds in its merchant account. The amount of time it takes to complete the settlement process will vary based on the issuing bank and type of transaction. Some authorized transactions may get settled immediately, while others could take hours, days, or even weeks to settle.
Examples of Settlement Strategies Used by Merchants
- A grocery or department store will settle authorized transactions immediately because customers leave with the purchased goods.
- A hotel may authorize transactions when a customer books a reservation but will not settle the transaction until a week after the guest checks out. This is a good idea since reservations may be canceled or updated for different dates or rooms.
- A restaurant likely authorizes a transaction when the customer pays their bill but will wait until after the tip is given to settle it, which will alter the total price.
- A virtual store will authorize a transaction during the checkout process. However, the transaction is usually not settled until the next business day when the products are confirmed and shipped to the customer.
Furthermore, merchants should be aware that authorization response codes provide a real-time update of a cardholder’s account status. While a cardholder may have enough money in their account now, it does not guarantee that the appropriate funds or credit will be available at a different hour, day, or week. Keep this in mind if your business postpones the settlement process. Unless you use an authorization hold, this could lead to not receiving payment from your customers.
If your business needs to delay the settlement process, it may be a good idea to add authorization holds into your payment process. Let’s take a look at how this works below.
- The customer places an order using their debit or credit card.
- Once the issuing bank authorizes the transaction, you can place an authorization hold on the transaction.
- This will hold the authorized transaction amount in the cardholder’s account, thus preventing them from spending those funds on something else.
- Indeed, this will guarantee that the money or credit will be there when you settle the pending transaction.
Secure Cardholder Data with Payment Tokenization
We hope this article helped illustrate the differences between payment authorization and settlement, the two-stage processes involved in credit card processing. Aside from knowing how this process works, it’s also essential to secure cardholder data to prevent payment fraud, chargeback fees, loss of profits, goods or services, and brand reputation. Today’s customers expect businesses to do everything in their power to protect and secure their payment details. If you don’t, they will probably take their business elsewhere. Learn more about our payment tokenization at TokenEx, so your business can enjoy improved payment security and fewer false declines and chargebacks without sacrificing critical business operations.