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As is my morning habit, I’m writing this while sitting in my favorite local coffee shop in downtown Boulder, sipping Sencha green tea. It’s a typical morning, lots of regulars and a few newbies, but the biggest change is a new policy in the shop: a $5 minimum on credit card purchases.

They’ve run their numbers and found that it would be less costly to take cash, up-sell customers, or even potentially turn a customer away than to run a credit card for under $5.

They’ve run their numbers and found that it would be less costly to take cash, up-sell customers, or even potentially turn a customer away than to run a credit card for under $5. Why? Because of the merchant fees associated with processing credit cards.

In 2008, the most recent number I could find, a subset of these fees (the interchange fee) added up to $48 billion dollars in the United States alone. That doesn’t include all of the other merchant account fees that can vary widely depending on your merchant agreement.

To me, that’s an astounding number that business owners (and, ultimately, consumers) are paying. And, with regard to internet sales, here’s the catch: you can’t take cash over a website. There is no option B.

Most of us are familiar with how credit cards (or debit cards) work from a consumer perspective, but for the uninitiated, here is what a typical setup looks like for a small business:

The Fees Compound Quickly

Let’s use the coffee shop as an example. First off, you need a Merchant Account. That can be obtained through a bank or a bunch of different merchant account resellers. Ultimately, even your bank is just a reseller. Next, you have to be approved (which is often a painful process). If you’re approved, then you set up the actual mechanism for taking cards. For a coffee shop, that’s some sort of card swipe machine. For an internet retailer, it’s probably choosing a Payment Gateway.

Before you even sell anything you’ve already racked up a monthly merchant account fee, an equipment rental fee (or a payment gateway monthly fee), a billing statement fee (no, it’s not optional), and an application fee to get the whole thing started. Some merchant account providers also have a monthly minimum fee (meaning you have to run enough transactions to meet a certain fee threshold for them or the difference is deducted from your bank account). Also, many merchant accounts require a several-year agreement with early-termination fees to lock you into pricing (and make it harder to switch to someone else once they start charging you hidden fees they haven’t told you about).

Let’s buy a $2 cup of coffee.

How does that work? The barista swipes your credit card. The data (amount, card number, expiration) goes out to the gateway and then to ultimate processor who checks with your bank and approves or disapproves the transaction.

Sidenote: One thing to realize is that at this point, your merchant account provider is usually completely out of the picture. They don’t actually have anything to do with processing the data, they just charge you for the privilege of acting like a filter/sales-force for the ultimate processor. They add little-to-no-value.

In total, that’s about $0.30 just for this transaction, leaving the coffee shop with $1.70 for your $2.00 cup of coffee.

To process this transaction, there likely was a gateway fee ($0.05), a per-item processed fee ($0.10) that goes to your merchant account provider, an authorization/interchange fee ($0.10) that goes to the processor, and a member fee (effectively $0.01) that goes straight to Visa or Mastercard. And then there is the transaction fee that is usually some sort of percentage. Let’s call it 1.85% or almost $0.04. In total, that’s about $0.30 just for this transaction, leaving the coffee shop with $1.70 for your $2.00 cup of coffee.

(What happens if the card is declined? The authorization and gateway fees still apply, but the rest don’t.)

The system, as it stands, is inflexible.

My theory (and it’s just a theory), is that credit card companies, on some level, stumbled into this gold mine. The system created by department stores and, eventually, credit card companies was shaped (for the most part) long before 2 things:

1. Widely-available credit
2. The internet

If you’re like me you tend to use a credit card out of convenience. I don’t want to carry cash. I would rather use a credit card and pay it off each month. The fact that most Americans can carry at least one (if not several) credit cards—or debit cards, which are processed the same way—means that most of us do the majority of our payment transactions with credit cards, out of convenience. As for the internet, if I’m shopping online, a credit card is my only option.

The credit card system wasn’t really meant to work this way.

I remember my mom writing checks at the grocery store. Checks! Now I’m irritated if someone even pays with cash.

Credit card companies have certainly encouraged this behavior, but it was meant for bigger transactions. When I was younger the only things my parents used a card for were bigger purchases. I remember my mom writing checks at the grocery store. Checks! Now I’m irritated if someone even pays with cash. A card is so much quicker!

Even just a few years ago you didn’t go to Starbucks and charge $2 worth of coffee on a card. You definitely didn’t spend 99¢ online for a song using a card.

…the raw deal is going to merchant selling smaller-ticket items.

Our habits have changed. That’s fine. The credit card system has not because it’s lucrative for it not to. Out of the fees I outlined above, $0.26 of them are fixed. If I buy a $2,000 TV or a $2 cup of coffee the merchant pays that $0.26. In that case, the raw deal is going to merchant selling smaller-ticket items. But, that raw deal is incredibly lucrative to merchant account companies, gateways, credit card companies, the ultimate card processors, and card issuing banks who are now earning 26¢ on all sorts of transactions that never used to be in the picture for them.

We’re stalled out

Unlike Eric Meyer, I don’t think this setup reflects a failure of capitalism. I think the current situation, as unfortunate as it is for anyone dealing with dollar amounts under $20, is a reflection of a stall. Progress isn’t constant. We’re in the situation we’re in because there is no incentive for the companies at the top to make any changes and no young upstart has found a way to successfully dislodge those companies, yet.

We need it to happen though. I got thinking about this after reading an excellent article by Frank Chimero on paying for content on the web. I tend to think that one of the reasons we’re struggling to find and build new payment models for content on the web is because the options for our current payment systems are prohibitive.

Short of a billionaire with a grudge who can change things with a new model overnight, the revolution will have to come in smaller intervals.

Short of a billionaire with a grudge who can change things with a new model overnight, the revolution will have to come in smaller intervals. It might take a new layer (like virtual currencies) or a new model (like a payment gateway that charges no transaction fees) to see things really start to change, but I’d like to think it will happen.

The unfortunate reality is that until it does, there is a whole world of economic possibilities and new business models for the internet that currently aren’t financially feasible.

Sidenote on the likes of PayPal (Google Payments, Amazon Payments, etc.) These payments systems have their place. For one thing, they have bargaining power. By processing a mass quantity larger of payments than the average small business they can negotiate better deals with the credit card companies. In some cases, they’re even experimenting with new models like micro-payments. But make no mistake, these systems are essentially a veneer placed on top of the existing processing system. They still have to pass on a lot of the same processing costs to the merchant and, at the same time, the average consumer is less trusting of an additional layer between them and the business they’re buying from.

Addendum: I’ve often wondered why small businesses like coffee shops don’t just charge an extra $0.25 for the convenience of using a credit card, rather than imposing minimums, but come to find out that charging such a fee would violate the merchant’s agreement with the major card companies. The companies, understandably, don’t want consumers to know the extra burden their credit card purchase puts on the small business.

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