What is a digital wallet and how does it work?
January 29, 2024
Losing your wallet or forgetting to bring it with you to a store can leave you in a bind. Worse, if your wallet is ever stolen, you’ll likely never recoup the cash it held, and you’ll need to replace your debit or credit cards, which takes time.
Thankfully, digital wallets have become a handy solution for those times when you’re in a pinch, offering a safe, reliable way to make purchases without the need for a physical card or cash.
Here’s everything you need to know about what a digital wallet is, how it works, and the pros and cons of this payment method.
What is a digital wallet?
A digital (or electronic) wallet is an application on your phone or smartwatch that securely holds your payment methods, like credit cards, so you don’t have to use the physical versions when making a purchase. Some digital wallets also hold tickets, like a boarding pass for a flight, loyalty cards, and even car keys.
How does a digital wallet work?
Digital wallets primarily rely on three technologies: near-field communication, magnetic secure transmission, and QR codes. Here’s how these work:
Near-field communication (NFC): Near-field communication lets two devices placed next to one another (for example, a cell phone and a payment terminal) exchange data.
Magnetic secure transmission (MST): MST technology sends a magnetic signal from a device to a payment reader.
QR codes: A user can scan a QR code with their phone’s camera, which then leads them to a website where they can complete purchases using information saved in their digital wallet.
Are digital wallets safe?
As with any digital transaction, there’s always a risk of hackers intercepting information. But digital wallet providers work to prevent users’ information from falling into the wrong hands by implementing a few critical safety features.
First, there’s tokenization, which is a process that masks your actual credit and debit card numbers when you make a payment. Instead of using your actual digits, the digital wallet generates a one-time token for each purchase. Since the payment recipient never receives your real credit or debit card number, you don’t have to worry about them misusing your digits to commit financial fraud or stealing your information.
Digital wallets also ask for your permission to make a purchase — usually requiring confirmation via fingerprint, facial recognition, or a secret passcode. This means if someone gets hold of your smartwatch or phone, they won’t necessarily be able to access your digital wallet.
For online purchases, digital wallets often use encryption, which employs complex algorithms to transform credit card information into unreadable code, ensuring secure data transmission. For added security, you can also protect your card data by using a masked credit card from IronVest, which links to your real payment source but creates unique, fake digits for the purchase.
What are the most popular types of digital wallets?
Here’s a list of some of the best digital wallets or payment applications that have a wallet feature you can use during your next trip to the store:
Apple Pay
Google Pay
PayPal
Venmo
Cash App
These digital wallets are “open” wallets, meaning you can use them at a wide range of points of sale — so long as the merchant offers the option. There are also closed digital wallets, which are merchant-specific. Amazon Pay and the Starbucks App are good examples of this concept, as you can only use these wallets to shop at Amazon or Starbucks, respectively.
Also, while there are a lot of digital payment providers on the market, not all have a digital wallet feature. For example, while Venmo (a peer-to-peer payment option) has made it possible to use its app in stores, similar apps like Zelle don't yet offer this same feature.
How is using a digital wallet payment similar to using a debit card or credit card?
Digital wallets and more traditional wallets work similarly in theory. Both hold your payment methods, which you can use to make purchases. And whether you use a digital or traditional wallet, you ultimately pull funds from the same accounts to cover purchases.
That said, digital wallets come with enhanced security and more ease of use. While your debit card requires that you enter your PIN as an added layer of protection on most purchases, it doesn’t encode your financial information like a digital wallet does. Making a purchase with your digital wallet is also a faster process — usually just requiring that you wave your phone or smartwatch past a payment terminal for a second.
Pros and cons of digital wallets
Digital wallets help billions of users make easy, safe transactions every day. But many people still swipe their cards and pay with cash, too. Here’s why digital wallets are especially helpful and when other payment methods still make more sense.
Pros
Digital wallets are convenient and secure thanks to the following features:
They omit your need for a physical wallet, so you don’t have to worry about having cards or cash on hand all the time.
They prevent merchants or unauthorized third parties from viewing your actual payment information.
They reduce transaction time, as digital wallet payments are nearly instantaneous. Swiping your card through a machine, entering your PIN or signing, then waiting for a physical receipt takes longer.
Cons
Digital wallets aren’t yet a solution for every in-person purchase. Here’s what holds this payment form back:
Not all points of sale accept this type of payment, so you may have to use your physical cards or cash in some settings.
You can only pay with a digital wallet if your device has battery power and is working correctly. If the device is off or your cell connection is weak, you may not be able to use this payment option.
Someone could steal the device with your digital wallet and access your financial information or make purchases if they can hack in.
How to pick the best digital wallet for you
If you’re ready to get started with a digital wallet, here’s some guidance on choosing the best option for your needs:
Choose a widely accepted app: Look at the payment processor at the coffee shop you go to every morning and the grocery store you frequent. Check out which digital wallets they accept. You’ll want to choose a wallet that works where you shop most.
Consider your device: If you have an app in mind, ensure it’s compatible with your device. Some digital wallets, like Apple Pay or Samsung Pay, only work on devices of the same brand. This means if you have an iPhone, you can’t use Samsung Pay, or if you have an Android phone, you can’t use Apple Pay.
Be aware of country restrictions: Some apps, like Venmo, only work on phones with U.S. numbers, so not all digital wallet options are suitable for international users.
Remember that it’s always a good idea to have a payment backup plan. If your phone dies before the end of dinner and you don’t have a physical card on you to cover the bill, you may find yourself in an uncomfortable situation. When you need to make a purchase (especially a big or time-bound one), it’s wise to pack your physical wallet before heading out.
Keep your payment information safer than ever
Using a digital wallet is a savvy way to increase the safety of your financial information and prevent the theft of your money or identity — all while saving time at checkout.
Level up the security of your payments even further by blocking your digital wallet with biometric login credentials. Get IronVest and protect all your passwords with biometric authentication, meaning only your face can unlock your accounts. Plus, you’ll gain access to IronVest’s virtual credit cards, which make online shopping safer as you never give your real billing information to merchants.