What are ACH Payments?
Automated clearing house (ACH) technology is a widely used but poorly understood form of payment. It supports credit transfer and direct debits and is primarily used for domestic payments between financial institutions.
In the U.S., several regional ACH associations were created in the ‘70s until in 1974 the National Automated Clearinghouse Association (NACHA) was founded. NACHA administers the network, but it does not operate the physical ACH Network. The processing of ACH transactions is handled by the Federal Reserve and The Clearing House.
ACH payment volume has increased steadily over the past decade. Last year, the ACH network processed close to 27 billion electronic payments, totaling $62 trillion. This represented 11 percent year on year growth in the total dollar volume of payments using this method. By way of contrast, there were 40 billion purchase transactions using credit cards in the U.S. in 2019 and $8 trillion in credit card purchase volume in 2020, according to the Nilson Report.
Types of ACH payments
Two types of payment via ACH exist, credit and debit.
An ACH credit is a type of ACH transfer where funds are pushed into a bank account by the payer. That is, the payer (i.e. the customer) actively chooses to move the funds to be sent to the payee (i.e. the merchant).
An example of this sort of transaction would be when an individual pays a bill through their bank or credit union. This would be processed as an ACH credit.
An ACH debit is a type of ACH transfer where funds are pulled from a bank account by the payee automatically. In other words, the customer previously gave permission to the merchant to take payment from their account whenever it becomes due.
For example, a regular recurring mortgage payment or utility bill payment would be paid using an ACH debit.
Most Americans are familiar with ACH without even realizing it through the direct deposit option most people receive from employers for their paychecks. Broadly speaking, all payments made via the ACH network are either direct deposits or direct payments.
ACH debits are a type of direct payment that is pulled out of an account by a payee. Direct deposits are when funds are pushed into an account by a payer, for example, an employer.
How ACH works
There are two primary types of financial institutions that operate within the ACH Network, the originating depository financial institution (ODFI) and the receiving depository financial institution (RDFI). ODFIs and RDFIs must adhere to strict regulations that protect and safeguard sensitive banking and client information. Financial institutions will usually be approved to serve as both ODFIs and RDFIs.
The ODFI is the financial institution where the ACH entry is originally placed. The ODFI must ensure that the original entry is accurate and then either debit money from the originating bank account or deposit money into it depending on whether an ACH debit entry or ACH credit entry was submitted.
To submit an ACH transfer request, the transaction originator must provide the following information to the ODFI:
- The name of the financial institution that will be receiving the funds on behalf of the individual
- The type of account that the funds will be deposited into (i.e., checking or savings account)
- The bank’s ABA routing number
- The recipient’s account number
- The name on the receiving bank account
The request will then be pushed through the Clearing House and Federal Reserve and then to the RDFI.
On the other end is the RDFI that receives the ACH entry. The RDFI has 48 hours to complete the request so that a return code can be processed. If a return code is pulled, it means that there was an issue with the ACH entry request. A return code indicates that the ACH payment request cannot be processed. This can be for many reasons, including insufficient funds, wrong payment data entry, or a compromised account.
If an ACH payment is returned, the OFDI will provide the originator with a reject code that explains what happened. The three most common reject codes are:
- R01 Insufficient funds
- R02 Bank account closed.
- R03 No bank account/unable to locate account.
If no return code is pulled, the money is transferred without a hitch and the transaction is settled.
Pros of using ACH
- Convenience – No more paper invoices and paper checks and time-consuming trips to the bank.
- Lower processing costs – ACH payments typically have the lowest processing fees of any type of payment. Some ACH processors charge a flat rate, which typically ranges from $0.25 to $0.75 per transaction. Others charge a flat percentage fee, ranging from 0.5 percent to 1 percent per transaction.
- Fewer declines due to expiration – Checking accounts don’t expire like credit and debit cards. That means you’ll experience far fewer declines when processing ACH payments.
Cons of using ACH
- Processing times – ACH payments are processed by in batches at set times throughout the business day. They don’t occur instantly and can take up to three working days to clear. Wire transfers, in contrast, are processed in real time, so money changes hands almost immediately.
- Penalties – Rejected ACH payments can cost your business a penalty fee. If you receive a reject code, it’s important to quickly correct the issue to avoid incurring additional fees in each recurring billing cycle.
- Transfer Limits – There can be daily and monthly caps on how much money you can move that are set by your bank. The Same Day ACH transfer limit is set at a maximum amount of $100,000 by NACHA after it was raised a year ago from $25,000. The network has proposed raising the limit to $1 million for Same Day ACH next year, which would enable companies to make the vast majority of their payments through ACH if they so choose.
- Cutoff times – After a certain time of day, a transfer won’t be processed until the next day (or Monday, if it’s before a weekend).
- U.S. only – U.S. banks don’t allow ACH transfers to and from international bank accounts. For international transactions you will need to accept credit card or wire transfer.
When to use ACH payments
From a cost perspective, it may make sense to encourage clients to make payments to your business through ACH if they are based in the U.S. However, please note that just like credit cards, ACH payments can be subject to chargebacks. Unlike credit cards though, ACH returns don’t have a representment process for the merchant to present their case. That means you should accept ACH payments only from customers you deem trustworthy.