What is direct debit? Examining the ACH 'auto-pay’ tool

A closer look at how ACH direct debit works, what it’s most commonly used for, and the benefits and setbacks that come with it

October 07, 2021

Tom is a fintech industry writer who creates whitepapers and articles for Plaid. His work has been featured in publications like Forbes, Fortune, and Inc. He's passionate about the freedom that the union between financial services and technology can create.

Billions of bills are paid each year in the US through direct debit, a type of Automated Clearing House (ACH) transaction that’s poorly understood despite its ever-growing popularity. This article aims to answer the questions that merchants and customers alike share about both the core direct debit system and the various enhancement products built on top of it.

What is direct debit?

Direct debit, also known as automatic transfer, authorized withdrawal, and auto-pay, is when a bill payer authorizes another party—such as an insurance company, utility, landlord, etc.—to withdraw money from their checking account on a specific date or at regular intervals using the ACH network.

It’s a convenient alternative to other bill payment methods where the payer has to remember to mail a paper check, drop off cash, or pay with a card via the phone or online. With direct debit, the payer only needs to provide their bank details once. Then, they enter into a standing agreement for their bank account to be regularly debited once per a given time interval, without any further action on their end.

Some common bills that are paid for with direct debit include software subscriptions, utility bills, and auto loans. It’s an easy way to pay any bill that’s regularly charged over a monthly, quarterly, semi-annually, or yearly basis.

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How does direct debit work?

In the United States, direct debits happen via the ACH network, a messaging system that connects financial institutions and enables them to coordinate funds transfers between their customers’ accounts.

For ACH direct debit transactions, the typical process looks like this:

1. A customer enters into a business agreement to make ongoing payments for regularly billed services such as life insurance, an auto loan payment, or a utility bill.

2. The consumer signs an authorization form (can be paper or digital) agreeing to have their bank account automatically debited, rather than manually pay for each billing period.

3. When it’s time to pay a bill, the payee (organization receiving the payment) submits an ACH debit request through an Originating Depository Financial Institution (ODFI) or ODFI-approved processing partner—which in most cases is their bank or a payment processor like PayPal or Dwolla. Once it’s processed, the ACH debit request instructs the ACH network to pull the requested funds from their customer’s account at the given time intervals.

4. The ACH network receives batches containing millions of these requests every hour, and settles between RDFIs and ODFIs accordingly. They rebundle the incoming batches at six set times each business day. These new batches get passed on to the banks for the accounts that receive these payments, which are called the Receiving Depository Financial Institutions (RDFIs).

5. The RDFIs download the incoming batches and execute the instructions, initiating return codes for any transactions they can’t process (wrong account numbers, insufficient funds, etc.) over the next two business days.

6. Once the transaction is settled, the payee receives their funds, typically within a day or so, depending on any risk delays imposed by the ODFI or payment processor.

→ Looking to reduce NSF fees and ACH returns? Plaid Balance allows companies to verify account balances in real-time to ensure users have enough funds to make successful payments.

When is direct debit used?

Direct debit is most commonly used for ‘set it and forget it’ bill payments, as it makes it much easier for people to pay recurring bills than mailing a check or entering their credit card info every month.

Direct debit is often used for:

• Fixed subscriptions and memberships (e.g., Netflix, Spotify, gyms)
• Regular bill payments (e.g., insurance, car loans, taxes)
• Paying down accounts (e.g., restaurant tabs, supplier payments)

For one-off ACH transactions that aren’t recurring, ACH credit (where the person paying originates the transaction) is more commonly used.

What is the difference between direct debit and ACH credit?

ACH direct debits can easily be confused with ACH credits, where the customer (the one paying) is actually originating the transaction. An ACH direct debit is the other way around, where the organization receiving the funds is the one originating the transaction.

The main differences between the two are:

• ACH debits are ‘pull’ transactions where the receiver of funds (the payee) originates the transaction and pulls money from the payer’s account. ACH credits are “push” transactions in which the payer originates the transaction and pushes money from their account to the organization they are paying.
• ACH debit transactions are frequently recurring, whereas credit transactions are typically standalone.

→ Ready for seamless ACH payments? Plaid Auth provides instant bank account authentication when users connect with their bank account credentials.

How do I process direct debit transactions?

Businesses that want to process recurring direct debits can use an ACH processing partner such as Dwolla or Square to set them up or can work with their bank. However, businesses originating payments online or via a mobile app will need to validate their customer’s bank account information before initiating an online ACH debit, as required by Nacha (the governing body of the ACH network). For that, there are several options which can take from a few seconds up to several days.

Plaid Instant Auth is an API-based solution that can validate accounts for direct debits in as little as 7 seconds.

What are the pros and cons of direct debit?

The advantages of direct debit are:

• Convenience: Payments are automatic and not conditional on customers remembering to make them.
• Cost: ACH fees and administrative costs are much cheaper for businesses than cards, checks, or wire transfers.
• Continuity: Bank accounts don’t expire but credit cards do.
• Predictability: Payment happens at the same regular interval and for the correct amount.
• Customer trust: Payers can easily return transactions they didn’t authorize.

The disadvantages to direct debit are mostly related to its slower settlement time than other payment methods:

• Fraudrisk: While ACH fraud is uncommon, bad actors can take advantage of slower ACH settlement and generous return rules.
• Insufficient funds: If a payment fails because there aren’t enough funds in the customer’s account, the business generally doesn't know for a few business days vs. nearly instantly for card-based transactions. However, Plaid can help mitigate that by providing real-time account balance information before an ACH direct debit is initiated.

ACH adoption is growing at a fast rate, with internet-initiated and peer-to-peer payments growing the most in the 2020s so far. With this growth, more innovative solutions that make ACH a better and faster user experience—including for direct debit—are sure to follow.