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What Is a Digital Wallet and How Does It Work?

Cash will never completely disappear. How else will the Marty and Wendy Byrdes of the world launder their money? Still, the role of cash continues diminishing as the world becomes ever more digitized. And it’s happening faster than you think.

Your smartphone now serves many of the roles formerly played by physical cards in your wallet. It gets better at being a digital wallet every year — whether you know it yet or not.

What Is a Digital Wallet?

Digital wallets are smartphone apps that store your payment information and securely transfer money to pay for goods and services. The oldest example is the PayPal app: you enter your credit card information, or link a bank account, and you can use the app to pay either businesses or individuals. 

But digital wallets go far beyond transferring money from one PayPal or Venmo account to another. Popular wallet apps like Google Pay, Apple Pay, and Samsung Pay use near-field communication (NFC) technology to make in-person credit card payments at the counter, without ever swiping your card. Like PayPal and Venmo, they also let you store cash and transfer it to other account holders. 

You can often store additional types of cards in digital wallets, such as gift cards, debit cards, and store loyalty cards.

Some digital wallets have also started incorporating cryptocurrencies. PayPal, for example, now lets you transfer and hold money in Bitcoin

Plus digital wallets come with all manner of promotions, deals, discounts, and rewards. You know the drill: “Get a $10 credit after you complete your first three payments!” and the like. 

Types of Digital Wallets

On the simplest level, digital wallets come in three types: closed, semi-closed, and open wallets. 

Closed digital wallets only function with a single retailer. For example, the Starbucks app serves as a digital wallet for Starbucks, allowing you to pay the coffee giant for your venti skinny mocha latte while tracking your rewards. 

Semi-closed digital wallets work similarly, but allow a list of several retailers. 

Open digital wallets work at any retailers whose checkout systems accept mobile payments. Look for the contactless symbol on the checkout stand.

You can also distinguish between digital wallets and crypto wallets, although the line gets blurrier every year. Digital wallets exist to let you pay for things, while crypto wallets exist to convert fiat currencies to cryptocurrencies, hold money in them, and transfer it to others. But with more retailers accepting payments in cryptocurrencies, and more digital wallets expanding to include them, the distinction starts to lose meaning. 

How Do Digital Wallets Work?

Digital wallets, sometimes called mobile wallets or e-wallets, work on several different technologies. 

Note that your choice of smartphone can impact your choices of digital wallets and payment methods. Apple Pay, for instance, only works on iPhones, not Android phones.

Peer-to-Peer Transfers

The simplest, and oldest, involves simply transferring funds from your account to someone else’s, as PayPal (and more recently Venmo) have provided for years. 

In this model, you open an account with the service, and link your bank account (and often a credit card) to it. You can send money to businesses or to individuals. 

These platforms also let you store funds directly in your account, so it operates as a secondary bank account for you. In many cases you can get a debit card to access the money via ATM or purchase.

QR Codes 

A more recent but still simple technology is QR codes: those little black and white square codes that you scan with your phone camera, which pull up a link. 

In the case of digital wallets, QR codes link to a page where you can submit payment with one click. 

MST & NFC Technologies

Magnetic secure transmission (MST) and NFC technologies work differently. These allow your phone to directly communicate with a nearby point-of-sale (POS) checkout device to submit payment. 

The payment system beams payment information, such as the retailer name and amount due, directly to your phone. You then approve the transaction with a single click on your digital wallet app. Because you must approve each mobile payment, retailers can’t charge you with your permission. 

Regardless of the exact technology used, the premise remains the same. Digital wallets let you authorize and transmit payment with your mobile device, rather than having to whip out a physical card or cash.

Beyond Money

Digital wallets increasingly let you store other important information securely. That includes travel boarding passes, hotel reservations, concert and other entertainment tickets, and corporate loyalty rewards. 

Plus, when you store this information in a mobile app, your phone can send you reminders or updates. For example, your digital wallet app can notify you of a gate change for your flight. 

Advantages of Digital Wallets

Digital wallets come with plenty of perks for technology-forward users — and increasingly for everyone else, too.

  1. Convenience & Ease of Use. By design, digital wallets let you make contactless payments with one or two clicks. They’re meant to be just as fast, if not faster, than swiping a credit card.  
  2. Less Clutter. The less you have to carry around with you, the simpler your life is. Digital wallets let you wander the world without a physical wallet in your pocket, at least in theory. And even if you do carry a small wallet, you can carry it solely as a backup, with a little cash and one emergency credit card. In other words, digital wallets can help you simplify your financial life.
  3. Contactless & Germ-Free: The word “contactless” has been one of those buzzwords of the pandemic, as we all became certified germaphobes. Blackhawk Network’s recent Global Digital Payments Insights report found that 59% of respondents started using, or increased their use of, digital wallets since the pandemic began. 
  4. Security. In many ways, digital wallets are safer than their physical counterparts. Digital wallets “tokenize” your information, which means they don’t store your credit card or other sensitive information directly. Instead, they create a unique code for it, which can’t be used by a hacker if stolen. When you pay, the digital wallet transmits the token code to the merchant services company (the payment processor), who is the only party who can match the token code with your actual card number. 
  5. Accessibility. Like online banking in general, you don’t need to visit a physical bank to open a digital wallet. That makes it easier for underbanked people in rural or other underserved areas to participate in the global financial system. Likewise, people in developing countries can open digital wallets even in the absence of a strong local banking network.
  6. Bonuses and Rewards. Digital wallets make it easier to capitalize on bonuses and rewards in several ways. They offer their own bonuses directly, such as incentivizing you to make your first three payments. But they also partner with other retailers to provide specific rewards with their partners. Plus, some digital wallets let you store third-party rewards or loyalty points within them. 
  7. Tracked Spending: Like Empower and other budgeting apps, digital wallets can help you track your spending, both overall and in specific categories. You can view your purchase history in real-time, and set up alerts for overspending. 

Disadvantages of Digital Wallets

For all their pros, digital wallets come with their fair share of downsides and concerns. 

Make sure you understand them before you start leaving your wallet on your dresser when you leave the house. 

  1. Safety Concerns. Between tokenization and other security requirements, such as unlocking your phone and then also unlocking your digital wallet app (often through biometrics such as your fingerprint), digital wallets are in many ways safer than physical credit cards, and certainly more secure than cash. But that doesn’t mean they come with no risk at all. Theoretically, someone with full access to your phone could go on a spending spree with your digital wallet.
  2. Privacy Concerns. Using a digital wallet means surrendering even more of your personal information to tech giants like Google or Apple. The more they know about your spending habits, the better they can sell ads that target you individually. 
  3. Not Accepted Everywhere. Not every retailer or restaurant has a sophisticated new checkout system with NFC or MST technology. For digital wallets to work, the vendor has to accept them. Many still don’t. 
  4. Dependent on Technology. Paying with your phone is all fun and games until your battery dies. Or you run out of data. Or you’re out of service coverage. Or you travel to another country with no local SIM card. For that matter, you could do everything right but the retailer’s POS system could crash, or their Wi-Fi network could go down. Technology is great — when it works. 

Final Word

At the very least, digital wallets help you avoid carrying around a Costanza wallet overflowing with cards, coupons, and crumpled receipts. You can carry a slim wallet with your license, one credit card as a backup, and a little emergency cash — lean enough cargo that it can fit on the back of your phone case. 

But beware of depending too heavily on digital wallets, as mobile apps can fail you at any time. And the more data you give tech giants like Google and Apple, the better they’ll be able to sell you things. Things you don’t need, and that you wouldn’t have bought otherwise. 

Embrace digital wallets if you wish. But as with any relatively new technology, be cautious at first.

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.