What is ACH?

Learn where ACH came from, what it is used for, and how it works

The Automated Clearing House (ACH) is a widespread network—but because it operates behind the scenes, it often prompts the question of, “What is ACH, exactly?” In short, ACH is what allows money to be sent electronically between accounts at banks. ACH often powers payments like paychecks sent via direct deposit, recurring bill payments, or peer-to-peer exchanges like Venmo or PayPal. We’ll dive into the question of what is ACH exactly by unpacking a bit about how it works.

What is ACH and where did it come from?

The ACH we know today was first developed in the early 1970s when the rampant popularity of checks introduced worries that computer systems used to process and clear checks would not be able to keep up. So, like so many other developments in financial services, several regional associations of banks within the American Bankers Association banded together to adopt a new system of processing payments, which improved efficiency and decreased paper waste. The early ACH network relied on magnetic tapes and diskettes that had to be physically moved from one bank to another. In 1974, the regional associations formed NACHA, the ACH network’s overseeing cooperative, and expanded nationwide. By 1994, the Federal Reserve required that all payments between any banks in the United States were to be transmitted electronically.

What is ACH used for?

Today, more than 25,000 financial institutions participate in the ACH network. More than 24 billion electronic transactions are sent across the network annually, consisting of more than $41 trillion in payments. In 2015, the number of transactions was 5.6 percent higher than the year before. The number continues to grow: The second quarter of 2016 also saw a 5.6-percent increase in transaction volume over the same period in 2015.

What ACH is most often used for is direct deposit payments, P2P payments, and healthcare payments. Each of those areas has seen major growth over the past year, with P2P payments most notably seeing a 670-percent increase, likely due to the rise of many third-party apps that make these types of transactions second nature.

What is ACH and how does it work?

ACH facilitates direct bank-to-bank transfers, meaning it uses customers’ bank account information, such as routing and account numbers or online banking login credentials, to access their accounts directly to debit or credit funds.

The process relies on several players, namely:

  • The originator of the transaction (in other words, the party initiating the payment, such as a business sending out payroll or an electric company collecting a monthly bill payment)
  • The originator’s partner bank, known as the Originating Depository Financial Institution (ODFI)
  • An ACH operator, like the Federal Reserve or The Clearing House, that receives batches of ACH payments from the ODFI
  • The Receiving Depository Financial Institution (RDFI), which processes the credits or debits sent by the ACH operator for the correct recipient
  • The recipient, who either has funds credited to his or her account (such as when he or she receives a paycheck), or has them debited from the account (when he or she pays a bill)

Third-party processors may also come into play when an originator does not have direct access to an ODFI, as not all banks play this role. Some of the most common processors are Stripe, Apex, and Braintree.

In order for credit or debit transactions to occur directly through the network, a user’s bank account must first be authenticated by the originator of the transaction. Verifying that accounts exist and have sufficient funds can help prevent errors. Moreover, verifying that a person claiming to own an account actually does helps prevent fraud.

What is ACH authentication?

There isn’t just one approach to authentication. There are several ways of authenticating a user’s bank account and identity:

  • Manual validation: A business can use a physical check to verify the user’s account and routing numbers and an ID to verify identity.
  • ACH validation test: Companies can send a “prenote” to their customers’ banks over the ACH network, which will verify the account—but not the user’s identity.
  • Micro-deposits: Small transactions of usually less than $1.00 are made in the user’s account. The user reports the sum to the originator to verify ownership of the account.
  • Validation services: This is a rarely used method, where a company can access a service provided by a bank or third party that provides account information.
  • Credential validation: This is Plaid’s preferred method of validation. A user logs in to a company’s service using the same login credentials he or she uses to do online banking. This method eliminates the inconvenience and slowness of micro-deposits and offers a secure and easy method of authorization.

What is ACH and how is it different from other payment methods?

While the ACH network and credit and debit card networks both move money into and out of users’ bank accounts, the networks themselves are quite different.

While debit card transactions and ACH debit transactions may seem quite similar (they both remove money directly from your checking account), the former requires a PIN or signature to verify the account and its available funds at the point of sale, while the ACH debit transaction uses routing and account numbers to authenticate the user’s account. When using a debit card, a customer also has the option of making an “offline” or “credit” transaction, which bypasses the network and gives the customer essentially a mini-loan without ensuring available funds. The payment is then processed at the end of the day. In addition to making payments, of course, the ACH network also allows users to receive payments, which the card network does not enable.

ACH was developed to provide an electronic alternative to checks. Electronic and card payments have drastically decreased check usage in recent years, and ACH has a few particular advantages over the paper method it was designed to replace. For example, it is more convenient and efficient, eliminating the need to manually write and deposit checks, which adds to overall user satisfaction.