Once upon a time payday meant visiting your boss's desk to collect a packet of bills (or even coins).
Then the system moved toward checks, as most employers began to count on their workers having access to a bank. The Friday paycheck became a part of the culture. For workers willing to wait, mail occasionally replaced picking up the check in person, but most people continued to prefer the certainty of holding their paycheck at the end of the day.
And there payment stayed for a surprisingly long time. Until relatively recently, if you had a job you took home your pay on a piece of paper. Even long after widespread adoption of ATMs, email and electronic transactions, the paycheck remained stubbornly relevant. As recently as 2011 a full half of small businesses continued to pay their employees the old fashioned way.
Fast forward to today. Approximately four out of five workers in the U.S. get their payment directly. The system they rely on is called "ACH." Here's how it works.
What Is ACH?
Automated Clearing House payments, or ACH, is a system of electronically transferring money directly from one bank account to another.
It's important to understand how this differs from most other forms of payment. With a debit card, credit card or check, your money has to go through several intermediate processes before it reaches its destination. For example, a debit card transaction takes place through the third party of the payment processor (almost certainly Visa (V - Get Report) or MasterCard (MA - Get Report) ). A check involves the physical check that you write, and the associated delays with moving and processing this document.
By contrast, an ACH payment is closer to simply handing someone cash in digital form. Your bank contacts their bank and each account is adjusted by the appropriate amount. This is closer to an immediate, bank-to-bank transaction… although as we'll see below, there is still a third party involved.
The ACH network is responsible for a wide variety of electronic payments. For example, many government institutions such as the IRS and the Department of Education only accept payments through ACH. Most employers use this system to pay their employees, and many businesses use it to purchase supplies through their vendors. When you receive a direct deposit, this is usually a form of ACH payment structured to occur in fixed, regular amounts.
ACH transactions cost less than the fees charged by payment processors and are often free. As a result they have become increasingly preferred in particular for large or recurring transactions.
What Is a Clearing House?
Many financial systems rely on the mechanism known as a clearing house.
While we could dedicate an entire article to this subject, in a nutshell the idea of a clearing house is a third party that balances all of the books at the end of each round of transactions. It helps to simplify complex, multiparty transactions and reduces the risk that someone won't make good on their end of the bargain. To do this, the clearing house acts as the opposite party for every transaction that passes through it.
For example, say that Robert owes Sara $20:
- Robert would pay the clearing house $20.
- The clearing house would collect $20 from Robert (taking the opposite of his position as a payer).
- The clearing house would pay $20 to Sara (taking the opposite of her position as a collector).
- Sara would collect $20 from the clearing house.
This gives each party confidence, as the clearing house secures both ends of the transaction. In financial markets, the clearing house can also play a role of holding collateral, collecting payments from traders in advance of risky trades to ensure that they can cover their position in case of losses.
Finally, the clearing house simplifies complex transactions. Say that Sara has payments coming from a dozen different clients and owes payments out to just as many. Through individual transactions, Sara's bank would have to adjust her account dozens of times per day. A clearing house would simplify this process into a single transaction. It would collect every dollar owed to Sara, pay every dollar she owes, then let her bank know the remaining balance at the end of the day.
How Does ACH Work?
So, understanding the role of a clearing house, how does the ACH system work?
An ACH transaction is a transfer between two banks that is processed by the Automated Clearing House system. (Hence the name.) This is a clearing house set up specifically to process payments between banks. There are two types of ACH transactions:
- Debits - These are payments made out of an account. For example, a $100 debit means taking $100 directly out of the individual's account.
- Credits - These are payments owed to an account. For example, a $100 credit means putting $100 directly into an individual's account.
An ACH debit transaction requires specific authorization for each transaction and amount. The exception to this is in the case of regular, pre-authorized transactions (such as direct deposits). For example, you could authorize a $100 transfer out on the 1st and 15th of each month to a specific individual. Changing that amount, the date or the recipient would require a new authorization.
An ACH credit transaction requires general authorization. The party putting money in needs your permission to access your account, but does not need specific authorization for any given transaction. You can send someone an ACH authorization form and this allows them to directly deposit money in your account on an as-needed basis until you withdraw that authorization.
To set up an ACH credit or debit, the party that wants to make the transaction needs the other party's banking information. For example, say you run a small business and want to pay a vendor for their services. You would initiate a debit transaction from your account and a credit transaction into their account, and would need the following from your vendor:
- Their bank name;
- Their routing number;
- Their account number (checking or savings);
- Their general authorization for ACH transactions.
Then you would specifically authorize the bank to make your payment into their account.
As we referenced above, an ACH transaction takes place in a few steps. For example, let's look at the payment situation above:
- You authorize the transfer from your account into the vendor's.
- The clearing house network will record that debit.
- The clearing house will then record all other debits and credits made against your account over the course of the business day.
- At the end of the business day it will add the total of your debits (money owed) and credits (money owed to you) and either pay you the difference or ask for that difference in one transaction.
- At the same time, the clearing house will add your payment to the vendor's list of credits.
- At the end of the business day, it will add the total of the vendor's debits (money owed) and credits (money owed to the vendor, including your payment) and again either pay or collect the difference.
While the ACH network processes credits and debits several times per business day, it can take several business days for a credit to process. The typical ACH payment processes in between two and three business days, although a party can request a larger gap between processing and payment based on their business cycle. For example, a business might process invoices on the 1st of each month but delay actual payments until the 7th in order to accommodate its accounting. This is common practice.
ACH vs. Wire Transfers
Finally, it's important to understand that ACH transactions are different from wire transfers.
A wire transfer is another form of sending money from one account to another using a third party such as Western Union (WU - Get Report) . In some cases your bank might process the transfer directly, eliminating the third party. In all cases, a wire transfer is a direct transfer of funds from one account to another. There is no intervening clearing house to ensure the fidelity of a transaction, and as a result the process is generally far faster, somewhat riskier and more expensive.
Wire transfers are generally relied upon for large or infrequent transactions, as the benefits of a clearing house tend to mainly benefit high-volume transfers.