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Introduction to How PayPal Works

The simple idea behind PayPal -- using encryption software to allow people to make financial transfers between computers -- 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 more than 100 million accounts worldwide.
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. We'll also examine some of the complaints about PayPal's business practices. Let's start with the basics.

Fundamentals of PayPal

PayPal is an online payment service that allows individuals and businesses to transfer funds electronically. You can use it to pay for online auctions, purchase goods and services, or to make donations. You can even use it to send cash to someone.
A basic PayPal account is free. You can send funds to anyone with an e-mail address, whether or not they have a PayPal account. They'll get a message from PayPal about the funds, and then they just have to sign up for their own account.
Funds transferred via PayPal reside in a PayPal account until the holder of the funds retrieves them or spends them. If the user has entered and verified their bank account information, then the funds can be transferred directly into their account. Other ways to withdraw your funds are listed below.

PayPalMethods of withdrawing funds from a PayPal account

Signing up for PayPal is quick and doesn't even require you to enter any bank account information, although a checking account or credit card is required to use many of PayPal's features. From the PayPal homepage, just click on the "Sign Up Now" button. 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 your own business, then a business or premier account would be more suitable. If you select a personal account, you can upgrade in the future.

Click on "Sign Up Now" to set up a PayPal account.

From there, you will go to a page that asks for your basic personal information -- your name, address, telephone number and e-mail address. You will also be required to enter two security questions in case you lose your password, and you have to enter a randomly generated series of letters and numbers, which help prevent fraud. Once you confirm your account by following instructions you'll receive via e-mail, the sign-up process is done.
Adding a valid, current credit card to your account will allow PayPal to confirm your address (if it matches where you receive your credit card statements). Having a confirmed address shows both buyers and sellers that you are less likely to be a scammer. You can also use your credit card for PayPal's

Expanded Use service, which allows you to draw money from the credit card, instead of just from a bank account.
If you want to add funds to your PayPal account from your checking account, or vice versa, you need to enter and verify your bank account with PayPal. When you enter your account number and routing number, PayPal will make two micropayments to that account. These payments are usually about 5 cents. PayPal will then ask you to enter those amounts in order to verify the account (they'll show up on your bank statement). After you enter them, your bank account will be ready for use.

PayPal Infrastructure

PayPal doesn't fundamentally change the way merchants interact with banks and credit card companies. It just acts as a middleman. Credit and debit card transactions travel on different networks. When a merchant accepts a charge from a card, the merchant pays an interchange, which is a small fee of about ten cents plus approximately 2 percent. The interchange is made up of a variety of small 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.
What part does PayPal play in all this? Both buyer and seller deal with PayPal, having already provided their bank account or credit card information. PayPal, in turn, handles all the transactions with various banks and credit card companies, and pays the interchange. They make this back on the fees they charge for receiving money, as well as the interest they collect on money left in PayPal accounts.
PayPal touts its presence as an extra layer as a security feature, because everyone's information, including credit card numbers, bank account numbers and address, stays with PayPal. With other online transactions, that information is transmitted from the buyer to the merchant to the credit card processor.
PayPal also offers a $5 PayPal Security Key -- 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 [source: PayPal].
All the money held in PayPal accounts is placed into one or more bank accounts, where PayPal collects interest. Account holders do not receive any of the interest gained on their money. Some PayPal critics claim that one of the reasons PayPal locks accounts and puts people through a long, frustrating appeal process is so they can keep the funds in the bank longer to collect more interest.

PayPal Account Types

The three PayPal account types differ in some important ways. All have access to PayPal's core features, which include:
  • Money Market
  • Virtual Debit Card
  • Account Insurance
  • E-mail Customer service
Personal accounts give you access to the core features, but that's all. Customer support is mostly via e-mail. There is a phone number available, but it is not toll-free and it sends users to a low-priority line with long wait times. There are no transaction fees for personal accounts, though there are fees for some other features, such as currency exchange. Personal accounts are also subject to volume limits of $500 per month. If you receive more than that, you will need to upgrade to a Premier or Business account (or deny the transfer that would have put you over the limit).

PayPal account types

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. Business accounts can also be set up for multiple users.
Business and Premier accounts allow access to all of the core features, plus the ability to accept:
  • Unlimited Credit Card Payments
  • Payment Receiving Preferences
  • Subscriptions
  • ATM/Debit Card
  • Mass Payments
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. Sending money is still free, but 2.9 percent is charged for funds received. Extremely high-volume accounts get a break -- after $3,000 has been received in a month, the percentage drops to 2.5 percent. Above $10,000, it goes to 2.2 percent, and money in excess of $100,000 received in a single month is only charged at 1.9 percent. In addition, all transactions in which money is received, regardless of volume, have a $0.30 fee added.

Using PayPal: Sending Funds

However, one of the keys to PayPal's success has been its ability to expand beyond the market. You can use it send money to a friend, donate to a charity and buy items from online merchants.

Sending money via PayPal is simple.

If you want to donate to a charity using PayPal, the process is just like sending money to anyone else. You need the charity's email address, or they might have a button on their website that allows you to make a donation directly. The main difference lies in the "Category of Purchase" entry on the PayPal payment page. Technically, this would be a quasi-cash transaction. However, such a transaction could be subject to fees, depending on the source of the money -- if you draw your PayPal funds from a credit card, you might be charged cash advance fees. You can just as easily select "Service" as the category, and the donation will work with no problems or fees.