How PayPal Works

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.

In the next window, you'll choose whether you want a personal, a business or premier account. If you just plan to use PayPal for eBay auction or other purchases, 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.

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

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. The account holder 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, a two-factor authentication (2FA) method that creates a temporary six-digit code when the user attempts to log in. PayPal sends the code to the user's registered phone. When entered, the code allows access to the PayPal user's account [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 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 de-facto default online payment service. Buyers wanted to use it because 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 $1.5 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 its accounts. By 2019, PayPal had 277 million active users and was available in over 200 countries [source: PayPal]. This worldwide expansion has brought PayPal a little closer to Thiel's and Levchin's original idealistic vision.

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

Earlier, we discovered that PayPal has three account types: personal, premier and business. All account types can send and receive money, but where PayPal appeals to individuals who want to make personal payments with security and flexibility, the company reaches out to professionals with a suite of other products, including online shopping carts, shipping assistance, and invoicing. PayPal also offers business loans to help fledgling companies get started [source: PayPal].

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 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.

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 website.

Premier and business accounts are similar, but business accounts 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:

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 website 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.

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:

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

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.

After you send money, the record of your transaction should appear on the Activity 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 website 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 MasterCard 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 [source: PayPal].

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

If you want to use PayPal to receive money, you have a range of options available. If you give someone the email 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. If you're selling from your own store or website, there are a number of options available for completing sales transactions with PayPal, including the following:

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 website 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 website development, this is a task you'll want to delegate to someone who is.

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. PayPal also charges fees for exchanging between the currencies it accepts 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. Unlike other fee-based services at PayPal, virtual terminal requires a subscription of $30 per month, or the equivalent of upgrading to a website payments pro account. The per-transaction costs mentioned above still apply in addition to this fee [source: PayPal].

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

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

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

One of the biggest criticisms of PayPal is that it acts like a bank, but it isn't regulated like one. Critics maintain 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 that follow.