what are chargebacks - credit card and phone on the table

What Are Chargebacks and How To Prevent Them

Tuesday, October 21, 2014
As a business, there’s nothing as frustrating as losing your hard-earned money – in any form. One of the ways this can happen is customer chargebacks. While unpleasant, learning more about what they are and how they work can help you avoid them in the future. In this article, we’ll take a look at the basics of chargebacks – how they typically work, how they vary from refunds, the costs for your business, and how you can work to prevent them. To get started, a chargeback is when a customer requests that their debit card or credit card payment is returned to them following a transaction. There are a number of reasons a customer may request a chargeback, but it’s important to note that a chargeback is a forced reversal of funds. However, this doesn’t mean that you as a business don’t get to defend yourself. More on that later. First, let’s learn how chargebacks work. 

Chargebacks: How do they work?

So that you fully understand the chargeback process, we’ll start by sharing the cycle from the beginning – when a customer makes a purchase from a business like yours.

Consumer purchase – A cardholder purchases a good or service from you, the merchant. This purchase could have been online, in-person, or over the phone.

Dispute initiation – The cardholder decides (for any number of reasons) that they want to dispute the credit card charge. They then contact the issuing bank to start the chargeback process. With the exception of rare instances, the customer is the one who initiates the chargeback process.

Bank communication – Next, the issuing bank contacts the merchant’s bank (sometimes referred to as the acquiring bank, since it received the initial transaction), asking for any documentation they can provide to refute the chargeback. Typical documentation to support the merchant’s case includes invoices, proof of delivery, receipts, communications, and anything else of note that would help the merchant contest the chargeback.

When the issuing bank alerts the merchant’s bank of the chargeback, the notification contains a chargeback code, which is a standardized reason for the chargeback. These reason codes can vary based on the card networks. For example, MasterCard and Visa might have varying codes.

Issuing bank decision – Now it’s time for the issuing bank to decide what to do. If the merchant’s documentation doesn’t refute the chargeback, or the acquiring bank does not reply with any evidence, the cardholder’s bank grants the dispute and returns the money to the cardholder, pulling it from the merchant’s account. However, if the merchant provides evidence that does refute the chargeback, then the issuing bank evaluates the situation and makes a determination.

Customer notification – Once the issuing bank has made its determination, they notify the cardholder. Should the issuing bank side with the cardholder, they'll issue the refund to the cardholder. Should the issuing bank side with the merchant, the customer can either accept the proof and pay the charges, or begin another process called arbitration.

Arbitration – If the two parties still do not agree, arbitration begins. This process now involves the credit card company (like MasterCard, Visa, American Express, or Discover). Both the issuing bank and the merchant bank present their evidence, and the credit card company makes a final decision that settles the dispute.

It's important to note that each credit card issuer will have varying time limits in place for chargeback dispute resolution. Broadly, consumers typically have only 120 days from the purchase date to file a chargeback with the card issuer. These limits help protect businesses and card issuers from the time, energy, and effort it takes to work through disputes.

Reasons for Chargebacks

Now that you understand the general chargeback process, let’s take a look at the common reasons chargebacks can happen. Historically, they were consumer protection measures – and they still protect consumers against fraudulent transactions. But, as the popularity of credit cards as a form of payment has risen, so have the instances of abusing the chargeback system. Here are a few of the most common chargeback reasons:

Suspicion of credit card fraud

A customer may not recognize the charge from your business on their account, which could indicate fraud. Often, this happens because their statement reads as a different name than the common name. This often prompts customers to file a dispute with the card issuer.

Shipping or delivery issues

If the customer doesn’t receive the item in a reasonable timeframe or never receives the item from you, they may file a dispute.

Product or service dissatisfaction 

Some customers file disputes if they aren’t satisfied with your products or services. With products, most often it’s due to a defect or the product being different than advertised. With services, quality can be seen as subjective and it’s often difficult to determine.

Friendly fraud

As previously mentioned, customers might use the chargeback system for nefarious reasons. Small business owners like you should be aware of these reasons so that you can combat them. These reasons are referred to as friendly fraud, which can include:
  • wanting to avoid paying restocking and/or return fees
  • experiencing buyer’s remorse
  • forgetting about a recurring subscription payment
  • waiting too long to return an item

Now that you know some of the most common types of chargebacks, we’ll take a look at the difference between chargebacks and refunds.

Chargeback vs Refunds

While they may seem similar, chargebacks and refunds have a few critical differences. The biggest difference is that a merchant grants a refund to the customer. In a chargeback, the customer is initiating the process through their issuing bank, without the merchant’s involvement. 

The second difference is the customer/merchant interaction. In a refund, the customer works directly with the merchant to get their purchase refunded. However, a chargeback involves the customer working directly with the issuing bank, often without the knowledge of the merchant. 

The next difference is while the merchant or the merchant’s payment processing company facilitates a refund, the issuing bank facilitates a chargeback. During the dispute process, the issuing bank pulls the money in question from the merchant and holds it until they reach a resolution.

Lastly, a refund can generally be executed more quickly than a chargeback. Because of the dispute process, resolving a chargeback can take up to 90 days. Conversely, settling a refund can happen within 7 business days.

For business owners, refunds are less expensive than chargebacks and do not harm the business’s reputation like excess chargebacks do. Losing out on money is never ideal for a business, so businesses like yours should focus on limiting both types of transactions. However, chargebacks carry costs and fees that make them even more costly for your business than refunds.

Fees associated with chargebacks

We’ve walked through the chargeback process. Now, let’s cover the fees your small business may experience when a chargeback is the business’s fault.

Chargeback fees

When a chargeback happens and it’s deemed legitimate, the merchant bank or payment processing company charges the merchant a chargeback fee to cover the cost of returning money to the original payer. These fees vary, but are usually a per-transaction fee and cover the cost of processing the payment back to the issuing bank. Check your merchant account agreement for more details on fees your bank may assess from you

Original processing fees

When someone purchases an item with their credit card from your business, you pay processing fees. If a customer’s chargeback request is successful, your business is still on the hook for the original processing fees.

Operational costs

As a small business, you know that there are a lot of costs that go into processing an order. From the inventory to the packing and shipping costs and logistics, these operational costs are sunk costs when a customer requests a chargeback.

All of these costs can really add up, and research suggests that it costs 2-3 times what they made on each chargeback. So for every $1 the customer spends, a business could spend $2 or $3 throughout the chargeback process.

Now that you’ve seen how chargebacks work and how fees associated with chargebacks can be so detrimental to your business, what can you do about it? 

How to minimize chargebacks

While it might be difficult to completely prevent all chargebacks, your business can take steps to minimize the chargebacks it experiences. Here are some ways you can protect your business from chargebacks.

Utilize best practices for accepting credit card payments

When your business accepts credit cards, it’s important for you and your employees to follow best practices – for both card-present and card-not-present transactions.

Card-present transactions
Although fewer disputes come from card-present transactions, you should always require your customers to tap or insert EMV (chip-enabled) cards. Because of regulations introduced by credit card companies, swiping a chip-enabled card instead of inserting or tapping it opens the merchant up to liability for any fraudulent charges. When possible, check the customer’s ID to confirm that it matches the card in use. In addition, make sure you provide a receipt so that customers have a record of the transaction.

Card-not-present transactions
In these transactions, the card is not physically present. This could be that you’ve keyed in the card information (like an over-the-phone takeout order) or that it’s being used for online transactions. In these instances, it’s important to collect extra information from the customer including the card number, the name on the card, billing address, expiration date, and CVV code. Also, it’s important to keep the tracking number and delivery confirmation for your records. For larger orders, you may opt for a signature proof of delivery. Another safeguard is to confirm that the billing and delivery addresses match. If not, call to ask your customer to explain why. If it doesn’t make logical sense, don’t accept the transaction.

Create clear, consistent, and visible business policies 

While adhering to the credit card best practices can help protect your business, your own business’s policies can help protect you from some of the friendly fraud scenarios we discussed earlier. That’s why it’s important to outline your refund policy, return policy, and cancellation policy. Then, be sure to post them clearly on receipts, online, and in-store. With a well-defined outline of your policies, customers will know what to expect when it comes to the return process and shipping times.

Be responsive to your customers

If a customer tries to contact you about an unsatisfactory product or service and can’t reach you, they might try to pursue a chargeback. That’s why it’s so important to be responsive to your customers, so you can remedy any customer service issues directly with the customer. This will save your business in the long run and build rapport with your customers.

Avoid confusion in branding

As we discussed, one reason chargebacks can occur is because a customer doesn’t recognize the merchant name as your business on their credit card statement. Therefore, it’s important to have a consistent naming convention across all consumer touch points. For example, customers might not recognize a fictitious “Atlantic Fish Company” if it shows up on statements as “Fish Atlantic.” Double-check that all of your branding is consistent to reduce the likelihood of chargebacks that stem from consumer confusion.

How too many chargebacks can affect your business

We’ve discussed ways to limit the number of chargebacks at your business. And while chargebacks themselves are expensive, they can also be detrimental to the longevity of your operation. That’s because too high of a chargeback ratio can make doing business very difficult. The industry standard is a 1% chargeback rate. Anything higher than this and you may be flagged as a high-risk merchant, which comes with some serious consequences.

Because of the risk incurred by payment processing companies and merchant banks, they typically take steps to protect themselves when dealing with high-risk businesses. Therefore, high-risk businesses face higher processing costs, limited cash flow if their bank decides to keep rolling reserves to mitigate risk, or even a loss of their ability to process credit card payments if their payment processing company deems them to be too risky.

As you can see, chargebacks are not only a headache – they can severely impact your business’s bottom line. After reading this article, you should be able to not only spot the various types of chargebacks, but also feel empowered to take the proper steps to limit them in your business. 

Ready to work with a partner who can help you mitigate chargebacks? 

Heartland is the point of sale, payments and payroll solution of choice for entrepreneurs that need human-centered technology to sell more, keep customers coming back and spend less time in the back office. Nearly 1,000,000 businesses trust us to guide them through market changes and technology challenges, so they can stay competitive and focus on building remarkable businesses instead of managing the daily grind.