Are automatic online payments a good idea?
Are automatic online payments a good idea?

Watch this Money Talks video to learn more about automatic bill payment -- the advantages and the disadvantages. See the pitfalls like overdraft protection, overcharges and the difficulty in withdrawing from auto-pay services.

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Introduction to How PayPal Works

The idea behind PayPal is simple: Use encryption software to allow people to make financial transfers between computers. That simple idea has turned into one of the world's primary methods of online payment. Despite its occasionally troubled history, including fraud, lawsuits and zealous government regulators, PayPal now boasts over 100 million active accounts in 190 markets worldwide [source: PayPal].

PayPal is an online payment service that allows individuals and businesses to transfer funds electronically. Here are some of the things you might use PayPal for:

  • Send or receive payments for online auctions at eBay and other Web sites
  • Purchase or sell goods and services
  • Make or receive donations
  • Exchange cash with someone

You can send funds to anyone with an e-mail address, whether or not they have a PayPal account. To receive the funds, though, the recipient must have a PayPal account associated with that e-mail address. Basic PayPal accounts are free, and many financial transactions are free as well, including all purchases from merchants that accept payments using PayPal [source: PayPal].

If you have a PayPal account, you can add and withdraw funds in many different ways. You can associate your account with bank accounts or credit cards for more direct transactions, including adding and withdrawing money. Other withdrawal options include using a PayPal debit card to make purchases or get cash from an ATM, or requesting a check in the mail.

In this article, we'll show you how to use PayPal, find out how the transactions are made, and learn something about the company's history. Let's start with how to sign up for your own PayPal account.

The PayPal home page includes links to sign in, sign up and learn more about PayPal services.

Screen capture by Stephanie Crawford for HowStuffWorks

Signing Up for PayPal

Signing up for PayPal is quick, and doesn't even require you to enter any bank account information. However, if you want to use many of PayPal's features, you'll need to add and verify a checking account or credit card. To get started, just click the "sign up" link at the top of the site's home page.

At the next page, you'll choose whether you want a personal, business or premier account. If you just plan to use PayPal for the occasional eBay auction or online purchase, a personal account is the right choice. If you intend to use PayPal to accept payments for a business, then a business or premier account would be more suitable. If you select a personal account, you can upgrade in the future.

From there, PayPal asks for some basic personal information: your legal first and last name, address, telephone number and e-mail address. You'll also need to check the box indicating that you agree to PayPal's user agreement, privacy policy, acceptable use policy and electronic communications policy. Once you click to create your account, you'll receive an e-mail with instructions for verifying your account and confirming your address.

From here, you should know what PayPal means when it refers to this verification and confirmation process. Having your information vetted by PayPal shows both buyers and sellers that you are less likely to be a scammer.

  • A PayPal account is verified if you've associated that account with a current bank account or credit card. This is more than just entering account information. PayPal will ask you to follow certain steps to complete the verification process. For a checking account, for example, PayPal will make two micropayments to that account, usually about five cents each. Then, you'll need to enter the amounts of those micropayments as verification.
  • A PayPal account is confirmed if you've completed one of three options to signal to PayPal that the address on your account is valid. The fastest of these is to verify a bank account or credit card matching the address you've entered as the PayPal account's address. As an alternative, you can request a confirmation code by mail after you've had the account for 90 or more days, or you can apply for a PayPal Extras MasterCard which confirms your address by running a credit check.

In the next section, we'll examine what parts make up the PayPal Web site and service.

Preventing Fraud in PayPal

After a series of scams exploited the company's payment system, PayPal formulated a plan to prevent criminals from using computer programs to open dozens of fraudulent accounts with stolen credit card numbers. This system, known as the "Gausebeck-Levchin" test, requires new account creators to type in a word found in a small image file on the account creation page. A script or a bot can't read this word; only a human can decipher it. Tests like this are more commonly referred to as CAPTCHA (Completely Automated Public Turing Test To Tell Computers and Humans Apart), a term coined by computer scientists from Carnegie Mellon University in 2000. Thousands of Web sites today use CAPTCHA or similar tests to automate their own anti-fraud detection. PayPal also uses special programs to detect potentially fraudulent activity. These programs watch for red flags that might be signs of fraud, such as sudden increases in volume or quantity of transfers, denied credit card charges or invalid IP addresses [sources: Balko, CMU, PayPal].

PayPal Infrastructure

From a buyer's perspective, PayPal changed the way people exchange money online. Behind the scenes, though, it didn't fundamentally change the way merchants interact with banks and credit card companies. PayPal just acts as a middleman.

To understand what that means, consider that credit and debit card transactions travel on several different networks. When a merchant accepts a charge from a card, that merchant pays an interchange, which is a fee of about 10 cents, plus approximately 2 percent of the transaction amount. The interchange is made up of a variety of smaller fees paid to all the different companies that have a part in the transaction: the merchant's bank, the credit card association and the company that issued the card. If someone pays by check, a different network is used, one that costs the merchant less but moves more slowly [source: Ellis].

What part does PayPal play in all this? Both buyer and seller deal with PayPal instead of each other. Both sides have provided their bank account or credit card information to PayPal. PayPal, in turn, handles all the transactions with various banks and credit card companies, and pays the interchange.

PayPal makes its own money in two ways. The first is the fees they charge to a payment's recipients. Though most transactions are free for the average user, merchants pay a fee on transactions. PayPal also collects interest on money left in PayPal accounts. All the money held in PayPal accounts is placed into one or more interest-earning bank accounts. An account holders doesn't receive any of the interest gained on the money while it sits in a PayPal account.

PayPal touts its presence as an extra layer as a security feature. That's because everyone's information, including credit card numbers, bank account numbers and address, stays within PayPal. With other online transactions, that information is transmitted across all the networks involved in the transaction, from the buyer to the merchant to the credit card processor.

As an added layer of security, PayPal also offers a PayPal Security Key, which is a portable device that creates a six-digit code every 30 seconds. The user links this key to his or her eBay or PayPal account. The six-digit code is used in conjunction with the user ID and password to create a unique security code. This extra service requires either a one-time purchase of $29.95 for the device or a mobile phone with text messaging to receive codes from a virtual key (the mobile service's SMS charges apply) [source: PayPal].

Next, let's roll back the clock and see how PayPal came to be the biggest name in online payment services.

Peter Thiel (pictured here) and Max Levchin founded Confinity in 1998 which became the foundation for PayPal.

Araya Diaz/Getty Images

PayPal History

Peter Thiel and Max Levchin founded PayPal in December 1998 under the name Confinity. Operating out of Silicon Valley, the idealistic vision of the company was one of a borderless currency, free from governmental controls. When venture capital funding combined with eBay transaction partnerships, PayPal quickly shot up to 1 million users after just 15 months [source: PayPal].

However, PayPal's success quickly drew the attention of hackers, scam artists and organized crime groups, who used the service for frauds and money laundering. New security measures stemmed the tide of fraud and customer complaints, but government officials soon stepped in. Regulators and attorneys general in several states, including New York and California, fined PayPal for violations and investigated the company's business practices. Some states, such as Louisiana, banned PayPal from operating in their states altogether. PayPal has since received licenses that allow them to operate in these places [source: Jackson].

Despite the initial turmoil, PayPal's market share continued to grow. Initially, PayPal offered new users $10 to join, plus bonuses for referring friends. The service grew so quickly that it soon became the default online payment service. Buyers wanted to use it since so many merchants accepted it, and merchants accepted it because so many buyers were using it.

In February 2002, PayPal held its IPO, opening at $15.41 per share and closing the day's trading above the $20 mark. PayPal owes much of its initial growth to eBay users who promoted PayPal as a way to exchange money for their online auctions. PayPal even beat eBay at the online payment business, trumping eBay's in-house payment system Billpoint so thoroughly that in October 2002, eBay bought PayPal for $1.4 billion in stock. eBay phased out Billpoint and integrated PayPal into its services. Sellers with PayPal accounts can place icons in their auctions so that buyers can simply click on the PayPal logo when they win an auction to make an immediate payment [sources: Kane, Wolverton, PayPal].

Since 2002, PayPal has remained a steady leader in providing online transaction services. It expanded its services in the United States to include such features as debit cards for the account. By the end of 2011, PayPal was available in over 100 markets for transactions in 25 international currencies. This worldwide expansion has brought PayPal a little closer to that original idealistic vision from Thiel and Levchin [source: PayPal].

In the next section, we'll learn about the different types of PayPal accounts.

Student Accounts in PayPal

In addition to the Personal, Premier and Business accounts, PayPal offers a Student account type with unique options suited to teens and young adults making their first financial decisions. A parent or guardian can open accounts for their kids ages 13 and up. Each account features a debit card for the student to make purchases anywhere MasterCard is accepted. PayPal also lets parents monitor the student's account, including receiving low balance and high spending alerts [source: PayPal].

PayPal Account Types

Earlier, we discovered that PayPal has three account types: Personal, Premier and Business. All these account types can use the following core PayPal functions:

  • Sending money
  • Requesting money
  • Using auction tools
  • Making payments from a Web site
  • Debit card services
  • Customer service

Besides these functions, the three accounts also share certain features and limitations. For example, if you have a verified account, you can send up to $10,000 in a single transaction, and there are generally no transaction fees for sending and receiving money between PayPal accounts. However, you'll pay a fee when using a PayPal debit card or receiving money for something that requires a currency exchange. Unverified accounts, including those without an associated bank account or credit card, have more restrictive sending and withdraw limits. You can determine the limits on your account by clicking a "view limits" link near the top of the page after you sign in to PayPal [source: PayPal].

The three PayPal account types differ in some important ways. First, Personal accounts give you access to the core features, but that's all. PayPal handles customer support for Personal accounts primarily by e-mail or through a virtual customer support agent at the PayPal Web site. There's a phone number available, but it's not toll-free and may have extensive wait times.

Premier and Business accounts are almost the same. The main difference is that a Business account must be registered with a business or group name, while a Premier account can be registered with a business, group or individual. Also, you can set up multiple users to access a business account.

In addition to PayPal's core functions, Business and Premier accounts provide these options:

  • Accepting debit and credit card payments
  • Allowing senders to set up recurring payments (subscriptions)
  • Unlimited use of a PayPal ATM/debit card

Business and Premier Accounts also get a toll-free customer service number and extended customer service hours. These extra features come at the cost of transaction fees, which we'll take a closer look at later.

If you're starting your own PayPal account for a business, compare the fees and services from PayPal against other credit card transaction services to determine which works best for your needs. Consider that with PayPal, most of the code you'll need to add to a Web site is automated for you, too. Shopping cart functions or "pay now" buttons may not be as easy to implement through other services.

Once you have your account, you're ready to send and receive money. Next, let's look at how to use PayPal for sending money.

PayPal's form for sending money is very simple: Just provide an e-mail address or mobile number plus the amount and purpose for sending.

Screen capture by Stephanie Crawford for HowStuffWorks

Using PayPal: Sending Funds

Though PayPal rose to stardom via eBay, one of the keys to PayPal's success has been its ability to expand beyond that market. You can use it to send money to a friend, donate to charity and buy items online. In order to send money using your PayPal account, you'll need one of two things:

  • Funds already transferred to your PayPal account before the transaction
  • An instant transfer account, usually a checking or savings account, from which PayPal will withdraw the necessary funds to cover the transaction

From there, it's just a matter of knowing your recipient. To send money to a person, all you need is the e-mail address associated with that person's PayPal account. For an organization or business, you can usually send money from a PayPal link at its Web site.

From the sender's perspective, PayPal is a free service. In fact, if you send money directly from a checking or savings account, there are never any fees involved. The one exception would be if you pay for something by taking a cash advance from your credit card. While PayPal might not charge you for this service, your credit card provider probably will.

One thing to be aware of when sending money, particularly with donations, is designating the money's purpose. In some cases, you'll link from the recipient's Web site to a shopping cart page that automatically makes this selection for you. If you click to "Send Money" from the PayPal Web site, you have the following two tabs of options to indicate whether you're buying something or just sending money:

  • Purchase tab with the options of Goods, Services or eBay items
  • Personal tab with the options of Gift, Payment owed, Cash advance, Living expense, Other

After you send money, the record of your transaction should appear on the History page at PayPal.com. If necessary, you can search that history for a specific time in the past. If you click the "details" link for a transaction, you can view all the details, including the amount, date, recipient and a unique transaction ID used by PayPal to track your transaction. If you ever dispute a transaction, customer service will use this transaction number when handling the dispute from both sides, sender and recipient.

If a Web site only accepts credit cards and not PayPal, you can still use funds in your PayPal account to make a purchase. To do this, you'll need to request a PayPal debit card which operates on the Master Card network. You can use that card number with any merchant who accepts MasterCard, and the funds will be deducted from the PayPal account. This service is free, but has a daily spending limit of $3,000. That debit card can also be used at ATMs to withdraw up to $400 in cash daily from your PayPal account, and it can earn 1 percent cash back on purchases if you're enrolled for PayPal Preferred Rewards through eBay.

In the next section, we'll see how both personal users and merchants can use PayPal to accept payments.

Using PayPal: Receiving Funds

If you want to use PayPal to receive money, you have a range of options available. If you give someone the e-mail address associated with your PayPal account, that person can send you money from their own PayPal account. If you're selling items on eBay, you can select PayPal as an option for accepting payment through eBay. If you're selling from your own store or Web site, there are a number of options available for completing sales transactions with PayPal, including the following:

  • Adding a PayPal "buy now" button for each item you want to sell
  • Integrating a PayPal shopping cart with your Web site using the PayPal application programming interface (API)
  • Accepting payments offline or off-site to process later using PayPal's Virtual Terminal

When you're signed in to PayPal, click the "merchant services" tab to see all the options available to you as a seller. Cost and availability of these services depend on which Web site payments type you've selected for your account. You'll have the "standard" type by default as a recipient, but you can upgrade to the "pro" type for a $30 monthly subscription fee. Merchants with a moderate to high volume of transactions each month should choose the pro type to avoid some of the fees commonly charged by other payment processing services, such as gateway and downgrade fees.

From the merchant services page, you can select the wizard tools to set up new "buy now" or "add to cart" buttons for your site. This generates code you can simply copy and paste into the HTML for your Web pages. When a buyer clicks one of these buttons, your site links to a shopping cart at PayPal's site to complete the transaction. This takes the burden off you, as a seller, of managing how that online shopping cart and checkout should look and function.

For more extensive integration, including hosting a PayPal-powered shopping cart from your own site, you'll need to use the PayPal API. If you're not savvy with computer programming or Web site development, this is a task you'll want to delegate to someone who is. See X.com for the technical details about the PayPal API and developing your site to integrate PayPal features.

Once you're set up to receive money, the burden is on you as the recipient to cover the transaction costs. PayPal charges its business and premier account holders a per-transaction cost of 30 cents, plus 2.9 percent of the transaction amount. If the merchant has a higher sales volume within a month, that percentage could drop to as low as 1.9 percent. PayPal also charges fees for exchanging between its 25 accepted currencies in international transactions. All these fees help cover PayPal's customer support and other services reserved for business and premier customers.

The last option shown above is accepting offline and off-site payments. This means you've taken the buyer's name and credit card information outside of PayPal. You can enter that information and process the transaction using PayPal's virtual terminal service. This tool is available from the merchant services page at PayPal.com. Unlike other fee-based services at PayPal, virtual terminal requires a subscription of $30 per month, or the equivalent of upgrading to a Web site payments pro account. The per-transaction costs mentioned above still apply in addition to this fee.

As a recipient, you can remove money from your PayPal account by making a withdrawal. These are your options for making the withdrawal:

  • Transfer money to a bank account associated with your PayPal account
  • Request that PayPal mail you a paper check for a certain amount
  • Make purchases using a PayPal debit card

So far, we've covered how to send and receive money with PayPal and how PayPal accounts work. On the next page, we'll take a closer look at the challenges PayPal has faced and the continued controversy over its business practices.

FDIC Pass-through Insurance

Although PayPal itself isn't an FDIC-insured bank, it does keep your funds in various FDIC-insured banks across the country (Go here to see which ones PayPal currently uses). According to PayPal, your funds are eligible for something called pass-through insurance. Basically, this means that you can recover your money even if the bank fails. This insurance does not protect you if PayPal fails, although the company claims that "your funds will also be protected from any claims of PayPal's creditors and will be returned to you even in the unlikely event of a PayPal insolvency" [source: PayPal].

Problems with PayPal

Though PayPal does have millions of seemingly satisfied customers, not all users have had such a pleasant experience. In fact, so many people have felt slighted by PayPal that entire Web sites exist to discuss problems about PayPal and mock its business practices. The most prominent is PayPal Sucks.

The biggest criticism of PayPal is that it acts like a bank, but it isn't regulated like one. This means that PayPal offers none of the protection that real banks offer, and it isn't required to maintain any of the security, customer service or dispute resolution services that banks provide. At the same time, PayPal holds large amounts of their customers' money, makes millions of financial transactions and even offers credit and debit cards.

So why isn't it considered a bank? In 2002, the Federal Deposit Insurance Corporation (FDIC) declared that because PayPal didn't meet the federal definition of an entity accepting deposits as a bank, hold any physical money or have a bank charter, it was not a bank [source: Wolverton]. In other words, PayPal isn't a bank because it doesn't call itself a bank. As a result, most states license PayPal as a "money service."

One of the most common problems encountered by PayPal users is the sudden and inexplicable freezing of their accounts. If your PayPal account is frozen, you can't add or withdraw any funds from your account, and you're required to go through a long, complicated process to verify your identity. Some users claim that PayPal has simply seized their funds and never returned them. Other complaints against PayPal include rude customer service representatives, a long and confusing User Agreement and loose hiring practices that may have led to account fraud [source: PayPal Community].

Despite these criticisms, PayPal continues to be the most popular money transfer service for online transactions. For more information on PayPal and related topics, check out the links on the next page.

Lots More Information

Sources

  • Balko, Radley. "Who killed PayPal?" Reason Magazine. August/September 2005. http://www.reason.com/0508/cr.rb.who.shtml
  • Carnegie Mellon University (CMU). "CAPTCHA: Telling Humans and Computers Apart Automatically." (Dec. 20, 2011) http://www.captcha.net/
  • Ellis, Blake. "Why banks are fighting over 12 cents." CNN Money. Cable News Network. March 11, 2011. (Dec. 21, 2011) http://money.cnn.com/2011/03/11/pf/debit_interchange_fees/index.htm
  • Jackson, Eric M. "The PayPal Wars: Battles with eBay, the Media, the Mafia, and the Rest of Planet Earth." World Ahead Publishing, Inc. 2004.
  • Kane, Margaret. "PayPal shares make strong debut." CNET. CBS Interactive. Feb. 15, 2002. (Dec. 21, 2011) http://news.cnet.com/2100-1017-838643.html
  • PayPal. "About." (Dec. 20, 2011) https://www.paypal-media.com/about
  • PayPal. "Frequently Asked Questions - PayPal Security Key." (Dec. 21, 2011) https://cms.paypal.com/us/cgi-bin/?cmd=_render-content&content_ID=security/security_key
  • PayPal. "PayPal Fees." (Dec. 20, 2011) https://cms.paypal.com/us/cgi-bin/marketingweb?cmd=_render-content&content_ID=marketing_us/fees
  • PayPal. "PayPal History." (Dec. 21, 2011) https://www.paypal-media.com/history
  • PayPal. "Purchase Protection: Transaction Monitoring." (Dec. 20, 2011) https://cms.paypal.com/cgi-bin/us/?cmd=_render-content&content_ID=security/buyer_protection
  • PayPal Community. "PayPal Community Help Forum: Disputes and claims." (Dec. 21, 2011) https://www.paypal-community.com/t5/Disputes-and-claims/bd-p/DAC
  • Wolverton, Troy. "Billpoint failure a lesson for eBay?" CNET. CBS Interactive. July 8, 2002. (Dec. 21, 2011) http://news.cnet.com/2100-1017-942231.html
  • Wolverton, Troy. "Feds: PayPal not a bank." CNET. CBS Interactive. March 12, 2002. (Dec. 21, 2011) http://news.cnet.com/2100-1017-858264.html