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Merchant account interchange fees affect businesses, card issuers

Increasingly controversial interchange fees ultimately paid by consumers

By Jeremy M. Simon

While many credit cardholders may not be familiar with interchange fees, merchants certainly are. That is because merchants are charged an interchange fee for each  credit card transaction. Interchange fees

Interchange fees are payments made between the merchant's financial institution, known as the acquirer, and the consumer's financial institution, known as the issuer. So while paying for a purchase via credit card may not end up costing you anything additional (provided you pay your monthly balance off in full), your choice to use plastic does cost the merchant.

Interchange fees are a component of the credit card networks.  The complex credit card network known as the multi-issuer card model is made up of a large number of participants, including the cardholder, merchant, acquiring bank, issuing bank and card association.  In a multi-issuer network, merchants are more willing to accept credit cards that have many cardholders, while cardholders want credit cards that are widely accepted.  Therefore, the payment networks benefits both the merchant and buyer and involves joint costs.  

The payment network must price its service so that it gets -- and keeps -- the two sides participating in the network.  It does this mainly by establishing interchange fees at levels that will maintain balance in the incentive structures of issuing banks (those that issue credit cards) and acquiring banks (those that service merchants and process their credit card transactions). Issuing banks collect interchange fees when they send payments for purchases to acquiring banks.

When your credit card transaction is approved, the issuing bank sends to the acquiring bank, via the network, the transaction amount minus an interchange fee.  This interchange fee is established by the card association.  In 2004, interchange fees were a source of about $25 billion in revenue for credit card issuers. 

Although they provide a solid revenue stream for the card issuers, interchange fees are an irritant to merchants and can be among the largest and fastest-growing costs of doing business for many retailers.  Generally, an interchange fee is around 200 basis points, plus 10 cents per transaction, although many transactions have lower fees and some have higher fees.  Major businesses can negotiate directly with the card association for low interchange fees, but these fees are not publicly reported.

Interchange fees have a complex pricing structure that depends on the card association, the type and size of the merchant, the type of credit card and the type of transaction.  Convenience stores, supermarkets, warehouse clubs and other merchants that sell low-margin items have lower rates.  Hotels and car rental businesses have higher rates. A newer premium credit card that offers more rewards will have a high rate.  Among transactions, those with a credit card have higher rates than those with a signature debit card, whose rates are, in turn, higher than PIN debit card transactions.  Sales that are not conducted in person, such as over the phone or Internet, have higher interchange rates, due to their increased risk of fraud.   

There is notable disagreement among network participants on the subject of interchange fees, with card associations coming under fire for the structure and application of those fees.  Merchants are increasingly seeing interchange fees as an unnecessary and growing cost over which they are powerless.  Additionally, banks are now issuing credit cards with even higher interchange fees.  Merchants view issuing banks as gaining revenue at their expense, without any added value for the merchants. Merchants pass on the cost of interchange fees to their customers, who are usually unaware of this expense.

Merchants are more aggressively challenging the interchange fee structure due to the fact it favors large merchants over smaller ones.  In early 2005, merchants established a trade association for the purpose of changing interchange fees.   

Visa and MasterCard have come under added fire to cut interchange fees. Regulators in Australia, the European Union and the United Kingdom, among others, have reviewed the effects of interchange fees on competition and questioned the level and collective determination of interchange fees.  Overseas, Visa and MasterCard have been pressured to lower interchange fees.

In spite of merchant dissatisfaction and regulatory scrutiny, card issuers have reason to keep or raise interchange fees.  This is largely due to the fact that issuers fund their highly popular reward credit cards through interchange fees.  Cards with reward or loyalty programs encourage greater card use and reinforce customer brand loyalty.

Published: August 15, 2006

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