Taking plastic is a smart move for the vast majority of merchants, and a necessity for any company operating online. Some key reasons to facilitate the use of credit cards include mitigating your business risk, selling your products online, and making your accounting processes drastically easier.

However, allowing customers to pay with a card comes with an increased risk of chargebacks, the bane of high risk merchants in every industry.

Need to reduce chargebacks as soon as possible but not interested in the heavy lifting? We’ve got you covered.

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Read on to learn exactly what a chargeback is, the different types, plus how you can prevent them from causing too much trouble for your business.

Table of Contents

  1. Definition
  2. Different Types of Chargebacks
  3. The Chargeback Cycle – Explained
  4. Why Chargebacks are Bad for Everyone
  5. Primary Examples of Credit Card Fraud
  6. How to Prevent Chargebacks
  7. Final Thoughts

1. Chargeback Definition

young man and woman in a white room looking at a whiteboard curiously

If you can define something, it becomes easier to comprehend.

Simply put, a chargeback is the return of funds from a merchant to a customer who used a credit or debit card to pay for that merchant’s products or services. They usually occur as a result of disputes lodged by customers, particularly ones who feel that they’ve been subject to fraud or unsatisfactory service.

Chargebacks are handled by the “issuing bank” – the institution which approved and furnished the customer with their credit card. When the chargeback occurs, the funds from the transaction are removed from your account and credited to the customer’s card.

It’s imperative that your chargeback ratio down, because you may get penalized or fined by your processor. Even worse, they may simply decide your business isn’t worth dealing with, and cut ties with you entirely.

2. Different Types of Chargebacks

chargeback, 3D rendering, traffic sign

Chargebacks can be a real hassle for merchants, especially high risk ones.

Major credit card companies such as Visa, MasterCard, Discover, and American Express have together created over 100 “reason codes” to classify the chargeback requests that they receive. For example, Visa has more than two dozen reason codes, ranging from to “Incorrect Currency” to “Not as Described or Defective Merchandise/Services.”

Although there are a variety of reasons why customers might request one, most can be categorized into any of the broader categories below.

Merchant Error

This category includes both technical problems and human error. The system might have charged the customer twice for the same transaction, or an employee may have entered an extra number to the price of the merchandise.

Issues with recurring transactions can also fall into this category. Customers may believe that they’ve already cancelled their subscription with your business, but are still being billed for your product or service.

Product Quality

In other cases, a chargeback may not be the fault of the merchant, but of another intermediary such as the shipping and handling company. Items that customers order may never arrive, or they may be different from how they were described at the time of purchase.

Fraud

Legally, customers are not responsible for most purchases that have been made as a result of identity theft or other fraudulent activity. This means that as the other party in the transaction, your business may be on the hook for the missing money.

To better catch instances of fraud, it’s important to understand your position as a merchant in the chargeback cycle.

3. The Chargeback Cycle – Explained

Chargeback icon. Glyph style is bicolor flat iconic symbol with rounded angles, green and gray colors, white background.

The chargeback cycle involves five key parties:

  1. The merchant
  2. The cardholder / consumer
  3. The issuing bank (the cardholder’s bank)
  4. The acquiring bank (the merchant’s bank)
  5. The card network (Visa / Mastercard)

And if arbitration is played out in its entirety, chargebacks have six main stages:

Stage #1: The consumer initiates a chargeback

This is done through the consumer’s bank, generally initiated on the bank’s website by the consumer. In order to begin the process, they must fill out a form and select a “reason code” for why they’ve chosen to file a chargeback.

Some example reason codes from Visa and Mastercard include:

  • Merchandise/Services Not Received
  • Not as Described or Defective Merchandise/Services
  • Counterfeit Merchandise
  • Misrepresentation

Stage #2: The consumer’s bank takes a close look at the case, and proceeds accordingly

There are two things that can happen at this stage:

  1. The bank finds the chargeback to be suspicious or invalid.
    Result: It’s voided, and nothing else will happen (no need to proceed to the next stage).
  2. The bank views the chargeback as legitimate.
    Result: The merchant’s bank will be notified, and money will be credited back to the consumer.

Stage #3: The merchant’s bank takes a close look at the case, and proceeds accordingly

If the merchant’s bank can prove the chargeback is not legitimate, they will handle everything for the merchant themselves.

If they can’t prove anything, they will move forward with the chargeback, and take money from the merchant’s account.

Stage #4: The merchant finally gets to see the case, and proceed however they see fit

If the chargeback is legitimate, the merchant must accept it and move on with life (and hopefully work on not getting similarly penalized in the future).

However, if the merchant has proof that the chargeback was fraudulent, they can build a case and hand it off to their bank for a second look.

Stage #5: The merchant’s bank initiates “representment”

All evidence gathered by the merchant will be taken by their bank, and used as the final case refuting the chargeback.

Stage #6: The consumer’s bank makes the final decision

There are two ways the chargeback cycle comes to a close:

  1. The evidence in favor of the merchant is sufficient to clear the merchant of blame, whereby the consumer gets charged again for the original amount. (Note that chargeback fees and other associated costs will not be refunded to the merchant)
  2. The evidence is not good enough, and the chargeback is finalized.

4. Why Chargebacks are Bad for Everyone

Tired stressed male worker taking off glasses, person massaging nose bridge suffering from headache and trying to relieve pain. Despaired man frustrated after reading company collapse or failure news

Chargebacks can be a major headache for consumers too.

A chargeback is a valuable tool for consumers when used honestly. However, the frivolous and fraudulent use of chargebacks has the power to make them negative for all parties involved.

Here are five reasons chargebacks are no fun for merchants or the consumers who initiate them:

1. They waste time and money

A chargeback can take weeks to months before coming to a resolution. Not to mention, if it’s deemed fraudulent, it could end up costing the consumer money in legal fees.

2. They can lead to closed bank accounts

Not just for merchants, either. Consumers who commit credit card fraud (intentionally or not) can get their cards closed – hurting their credit score in the process.

3. They can hurt a consumer’s credibility

Sometimes, chargebacks are unavoidable for consumers. However, consumers who build reputations as frequent users (and potential abusers) of the chargeback system will be viewed with greater skepticism by their banks. When they actually need help, it might be harder to come by.

4. They can lead to higher product/service prices

Merchants who constantly need to deal with chargebacks will inevitably have to raise their prices, hurting their business as well as the pocketbooks of their valued customers.

5. They can close a business

Excessive chargebacks will result in a merchant getting their processing capabilities frozen or canceled altogether. Consumers should think twice before resorting to this process, and first go to the merchant to solve their issues. Such actions can have a quantifiably negative impact on a company’s future.

Both you and your customers have a vested interest in keeping chargebacks as infrequent as possible. However, we live in an imperfect world, and sometimes they’re necessary.

Even worse, some people try to game the system at the expense of honest businesses. In the next section, we’ll go over the different types of credit card fraud you may encounter as a merchant.

5. Primary Examples of Credit Card Fraud

Interested curious corporate spy looking at colleagues laptop, spying on rival, cheating on examination, stealing idea, sneaking peek, taking inquisitive glance at computer screen of unaware coworker

It’s always good to be careful when looking at your personal information in public.

True Fraud

True fraud occurs when a customer becomes the victim of identity theft due to unauthorized use of their card. This can occur for several reasons:

  • The card data may have been exposed during a massive data breach at a retailer, such as Home Depot or Target.
  • The card may have been lost or stolen, and subsequently discovered by a malicious actor.
  • The card data may have been captured using a “skimmer,” a small device that thieves place over the credit card slot in places such as gas stations and ATMs.
  • The customer may have entered their card data into a malicious website or provided it to a scammer over the phone.

Regardless of the reason, true fraud can be devastating to your business. Merchants lose $190 billion every year as a result of credit card fraud.

Friendly Fraud

While the name “friendly fraud” sounds like an oxymoron, it’s a very real phenomenon, responsible for 28 percent of all merchant losses to fraud.

In fact, the term “friendly fraud” is a bit misleading. It occurs when customers file a dispute without intent to defraud the merchant, but also without being in the right.

For example, a customer may request a chargeback because they don’t recognize a transaction on their credit card statement. However, the transaction isn’t actually fraudulent: it may have been a family member using the card, or the customer may have simply forgotten about a recurring charge on their account.

Chargeback Fraud

While true fraud occurs as a result of identity theft by a third party, chargeback fraud occurs when customers themselves are the ones attempting to defraud the merchant.

By filing a credit card chargeback request, some customers hope that they’ll be able to get their funds back while also holding onto the product or service that they’ve already received. They may also want to purge a purchase that they regret from their card history.

During chargeback fraud, customers will provide a number of illegitimate reasons for requesting a chargeback:

  • The customer did not receive the product or service
  • The product or service was not as described, damaged, or defective.
  • The customer had already requested to cancel a recurring transaction.

6. How to Prevent Chargebacks

metal chain and lock on a chain fence

Preventing excessive chargebacks is a good way to make your provider happy.

Most chargebacks occur when customers feel unsatisfied with the product or service that they’ve received from your business. In order to keep your clients happy and protect your business against fraud, there are a number of steps that you can take to prevent such requests:

Step 1: Use a clear descriptor for transactions

If customers don’t recognize the name of the merchant, they’ll be much more likely to file a chargeback. Make sure that the transaction’s description helps customers recall the purchase.

Step 2: Be proactive in customer service

Customers who are dissatisfied with their product or service are also more likely to file a chargeback. Reach out to customers who leave bad reviews or who complain about your company on social media, and encourage them to contact you before their card company.

Step 3: Keep records

Don’t rely on your payment processor alone to help you fight fraudulent chargebacks. By keeping your own records of transaction times, dates, and amounts, you can win more disputes in the event of friendly fraud and chargeback fraud. Using receipts or payment contracts also helps you prove that the customer had authorized the transaction.

Step 4: Use the right payment processor

Not all payment processors are created equal. Some have extra features to help prevent fraud or to cover losses in the event of a chargeback. By looking for these merchant-friendly processors, you can reduce your liability.

7. Final Thoughts

Credit card chargebacks are a necessary evil to ensure that customers are defended against identity theft and unauthorized use of their card information. However, you need to make sure that your business refunds customers with legitimate complaints too. It’s a tenuous balance, but if you learn to manage it, your business will be in a good position to succeed.

Want to learn how to reduce your risk, in terms of not just chargebacks but other payment problems merchants encounter these days? Set up an appointment with our team of experts, and we’ll connect you with both credit card and chargeback solutions that will help you grow and protect your business.

About the Author

Geoff Scott is a Payments Consultant for Motile LLC, where he strives to connect users across the internet with processing solutions for their small businesses. He also loves Thai food, craft beer, and an exhilarating game of squash (when he's off the clock, of course).