How Pre-Authorization Can Optimize MDRs and Reduce Chargebacks

How Pre-Authorization Can Optimize MDRs and Reduce Chargebacks

Pre-authorization stands as a powerful means to optimize Merchant Discount Rate (MDR) expenses and mitigate chargebacks. Unfamiliar with this strategy? Allow me to shed light on this critical aspect.

In this article, we will delve into the realm of pre-authorization in the context of payments, uncovering its mechanics, its applications across various industries, and the substantial advantages it offers in terms of cost savings and chargeback prevention. Stay with us for the full scoop.

Understanding Pre-Authorization in Payment Processing

Authorization represents a pivotal step in the process of finalizing credit card payments. Its role involves validating the viability of the chosen payment method for transaction completion. Should the payment method prove valid, the transaction amount is temporarily secured by the issuing bank (the customer’s bank) for a specific period, typically spanning 7 to 30 days, contingent on factors like the merchant category code (MCC). This temporary fund reservation goes by various names, including pre-authorization, pre-auth, or authorization hold.

During the period of this authorization hold, the merchant has the opportunity to initiate the second step in credit card payments – the “capture.” If executed within the allotted timeframe, the payment is credited to the merchant; otherwise, it is returned to the customer.

Let’s delve into the intricate workings of pre-authorization.

The Mechanics of Pre-Authorization

Here’s an overview of the typical steps involved in a pre-authorization process:

Customer Initiates the Transaction: When a customer makes a purchase, they input their payment details on the merchant’s platform, which initiates the transaction.

Merchant Requests Pre-Auth: Upon receiving the payment information, the merchant submits a pre-authorization request to their Payment Service Provider (PSP), provided it supports this feature, to authenticate the transaction.

Processor Conducts Verification: The PSP or gateway performs checks to ascertain the availability of sufficient funds in the customer’s account and to evaluate other criteria required for transaction completion.

Processor Holds Funds: If the processor confirms the transaction’s feasibility, they endorse the pre-authorization request and set aside a designated amount from the customer’s account. This sum becomes temporarily unavailable to the customer but remains uncredited to the merchant.

Merchant Completes the Transaction: Once the funds are held, the merchant can proceed with the transaction by issuing a “capture” request.

Fund Settlement: Following transaction completion, the payment processor disburses the funds into the merchant’s account. The swiftness of fund settlement may vary, ranging from instant to several days, contingent on the payment processor’s policies.

Now that we’ve outlined the fundamentals of pre-authorization, you might be pondering the rationale behind holding funds, considering it seemingly prolongs the time before a merchant can access their funds. This common perspective merits a more comprehensive understanding.

Diving Deeper: The Purpose and Industries Leveraging Pre-Authorization

The chief purpose of pre-authorization is to validate the suitability of the chosen payment method for the transaction. This assessment encompasses several factors, including the assurance of adequate funds to facilitate the transaction. When everything aligns, the funds essential for the transaction are temporarily secured.

While the concept of payment holds might seem redundant for brick-and-mortar stores where goods are immediately handed over upon purchase, it holds significant relevance for specific businesses, both in the physical and digital spheres, where merchants encounter financial risks.

To shed light on the matter, let’s explore industries that actively employ pre-authorization to their advantage:

Hotels: Pre-authorization proves invaluable for hotel proprietors, particularly during guest check-ins when the final charges remain uncertain. By implementing pre-authorization, they can reserve a higher amount on the customer’s credit card, assuring their capacity to cover potential expenses. In case of damages or additional charges, the hotel management can seamlessly address these without complication. If no such issues arise, an amount less than the reserved sum is captured.

Healthcare Enterprises: Another sector embracing pre-authorization is healthcare, encompassing hospitals, medical practitioners, and clinics. When patients are admitted, a fund hold is established, which remains in place until the services are provided. This practice ensures that healthcare service providers receive full payment for the services rendered.

Car Rental Services: Car rental businesses confront uncertainty regarding the condition in which vehicles are returned by customers. Hence, they utilize pre-authorization to secure a higher amount, safeguarding themselves against potential damage costs. When the vehicle is returned without any issues, a sum lower than the initially held amount is settled.

E-commerce Ventures: E-commerce entities often impose a fund hold when customers place orders without immediate charges. Payment is only processed when the order is dispatched. This approach safeguards merchants, guaranteeing payment, and shields them from common occurrences of order cancellations or refund requests.

Subscription-Based Businesses: Subscription-based enterprises leverage pre-authorization to ensure regular monthly, weekly, or yearly payments from their customers. Upon customer sign-up and provision of card details, a specific amount is held, instilling confidence in merchants that they will be compensated for their services.

Mitigating Chargebacks Through Pre-Authorization

Here’s the approach to reducing chargebacks through pre-authorization:

Typically, customers file chargebacks for two primary reasons:
  • To defraud the merchant.
  • As genuine victims of fraud.

In either scenario, when a customer initiates a dispute, the merchant often finds themselves with no recourse but to contest it, often incurring chargeback fees, which can be a considerable financial burden. Notably, certain payment gateways, like Stripe, have ceased refunding chargeback fees to merchants, even in cases where the merchant prevails. This situation can be financially onerous.

However, merchants employing pre-authorization can avert such situations. By holding the transaction amount, customers are effectively barred from filing chargebacks, as the money was never truly utilized. Any attempt to dispute the transaction results in the bank’s request to release the hold and the associated funds. This proactive strategy spares merchants from chargeback fees and undue complexities.

Unlocking MDR and Transaction Fee Savings via Pre-Auth

Beyond chargeback prevention, pre-authorization holds the potential to generate savings in terms of Merchant Discount Rates (MDR) and transaction fees. Here’s how it works:

MDR, or Merchant Discount Rate, represents a percentage-based fee imposed by payment processors for facilitating debit and credit card transactions. Typically, this cost is passed on to the customer as part of the overall transaction cost. Consider a scenario where a merchant employs pre-authorization for transaction validation. In cases where transactions are validated, the merchant incurs an MDR charge. However, if the transaction is declined or the authorization hold expires, no MDR is levied. In essence, the use of pre-authorization allows merchants to circumvent MDR charges for unsuccessful transactions, leading to cost savings.

In addition to MDR, merchants often encounter interchange fees, which contribute to the overall transaction expenses. The implementation of pre-authorization offers relief in this regard. Until the authorization is confirmed and the customer’s account is debited, merchants are exempt from interchange fees. If a transaction is canceled while in the hold stage, interchange fees are avoided, resulting in a reduction in the total transaction expenses and, consequently, financial savings.

Navigating the Potential Pitfalls of Pre-Authorization

While pre-authorization is a potent tool for payment security and chargeback mitigation, its utilization demands a degree of prudence. At times, it may inadvertently lead to an upsurge in chargebacks.

Consider the following example:

Suppose a pre-authorization request is initiated, but the transaction is not completed within the specified timeframe, causing the hold to expire, and the amount to be reimbursed to the customer. Customers, often unaware of the timeframe for authorization holds, might misconstrue the situation as a double charge, potentially prompting them to file chargebacks.

Furthermore, if the captured amount exceeds the initially held sum, customers might perceive this as fraudulent activity, leading to further chargeback claims. Therefore, merchants must exercise caution when employing pre-authorization, emphasizing clear communication to avert misunderstandings.

In Conclusion

Embracing the potential of pre-authorization can unlock a multitude of benefits for your business, particularly if you operate within the realms of hospitality, rental services, e-commerce, or similar sectors. By implementing pre-authorization, you can rest assured of receiving payments, while simultaneously sidestepping the burden of transaction costs and chargebacks.

For businesses in these sectors, and others sharing similar dynamics, the incorporation of pre-authorization is advisable. However, it is essential to use this tool judiciously and ensure that customers are well-informed to prevent any potential confusion.

Pre-authorization: The Gateway to Financial Efficiency and Security.

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