Understanding Credit Cards: How are Credit Cards Processed?

by Amy Lillard

Credit and credit cards are an integral part of our economic system today. But there is a lot of misinformation and misunderstandings about credit. In this continuing series, we examine key concepts, tips and best practices when it comes to credit cards.

(11/21/2012) Using credit cards is an easy and increasingly common way to make purchases. But have you ever considered what actually goes into the magic of credit card purchases?

Today credit cards have evolved to have purchasing power on a local, regional, national and international scale, as well as throughout the Internet. It's possible through a series of relationships and approvals that seem instantaneous to purchasers, but are actually fairly involved. For a typical transaction, up to 7 participants may take part:

• Customer
• Merchant
• Payment gateway
• Acquiring bank's processor
• Credit card interchange
• Customer's credit card issuer
• Merchant's acquiring bank

How does it work? At a physical store, a credit card reader called a terminal registers tiny magnets in the card's magnetic strip which contain the digital details of a card and card holder. The terminal reads the card information and combines it with the information specific to the transaction. Online, a consumer simply adds their credit card information in manually.

At this point, the terminal or the server creates a secure and encrypted data connection with a payment gateway, which is connected to major credit card networks including Visa, Mastercard, Discover and American Express. The gateway forwards the information on to a processing network, which then forwards it on to the bank issuing the credit card.

The bank's computers evaluate their own information about a card and a card holder — status of the card, amount of credit available — and combine it with information on the transaction and the merchant. The bank then issues a message — approval, decline, or instructions to contact the bank — which is sent back to the terminal or online merchant. If approval was granted, the transaction is completed. If denial or further instructions were issued, the merchant will act accordingly.

This all happens in the blink of an eye. But each step is essential, and each party involved charges nominal fees, which are part of the overall purchase price.