This article originally appeared on informed-merchant.com, a blog started by one of our founders, Sean, before he started FeeFighters.
One way that processors make extra money is by using a strategy that we call “Marking Up Downgrades”. Most merchants are charged for processing services according to a Three Tier Rate Structure. Each transaction is put into one of three categories: “Qualified”, “Mid Qualified” and “Non Qualified”. Transactions classified as “Qualified” will be charged the base rate. Transactions classified as “Non-Qualified” or “Mid-Qualified” will be charged extra.
The category for each transaction is decided based upon how the transaction was processed and what kind of card was used:
- example: If an online store does a transaction without address verification then the rate will often be downgraded from “Qualified” to “Non-Qualified”
- example: If a rewards card is used, the transaction will often be downgraded from “Qualified” to “Mid-Qualified”.
How it works
The reason why processors charge extra for these kinds of transactions is that they get charged more for those transactions by Visa and Mastercard (see What Is Interchange for more detail) so that Visa and Mastercard can pay for the rewards. However, they usually pass through MORE than the extra amount to the merchant.
For example, a transaction using a “Visa Signature” Rewards card typically costs the processor about 0.40% more than a typical consumer credit card, but the amount passed on to the merchant is usually at least 1.00% and often as much as 2.00%.
Rewards cards have become much more popular lately, so these charges can really add up, which is a shame because most merchants pay most of their attention to negotiating the Qualified Rate and ignore the other rates. One friend of ours was told by his processor “don’t worry about that, it’s just for special cases and doesn’t happen very often”, which is a bit deceptive in our mind.
Something to watch out for: the criteria for determining which tier each transaction is classified into is based on a case-by-case basis and is usually not specifically defined in the contract. This can make it hard to price compare between processors because what might be “qualified” to one processor can be “mid-qualified” to another processor (see “Inconsistent Buckets“).
A reasonable markup, which covers the increased interchange cost for Mid Qualified transactions is less than 0.20% (20 bps). I based this assumption on the difference between rewards and non-rewards interchange rates.
For non-qualified a reasonable markup is no more than 1.00% (100 bps). I based this on the difference the VISA EIRF (a common rate for cards that were settled without proper identification or not settled in a timely manner) and VISA Retail interchange rates , which is 0.70% (70 bps)
Our article “Reading a 3-Tier Merchant Statement” shows a good example of this practice. Here the Mid-Qualified Rate is an extra 1.00% and an extra 0.10. That is on top of the overall rate of 2.520%. So the Merchant Account Provider in that case is making an approximately an extra 0.80% + 0.10 on each of those Mid-Qual transactions, adding up to almost $500 extra that month for the merchant. The Non-Qualified rate is similarly marked up, to 1.50%.