What is a Digital Wallet? And How Do They Work?

Written by Andrew ElyUpdated: 3rd Nov 2022
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Digital wallets are another way that the internet, neobanks, and financial technologies are making our lives easier, safer, and plastic-less.

Their popularity surged throughout the pandemic as consumers flocked to contactless payment methods and sought out technologies to simplify their finances.

But if you haven’t hopped on the train yet, you may be wondering: just what is a digital wallet?

What is a Digital Wallet?

A digital wallet, sometimes called an e-wallet, is just what it sounds like: a digitized wallet on your computer or smart device that stores your payment and financial account information.

These negate the need to carry around debit or credit cards, coupons, or loyalty cards, among other items.

Instead, you store the information on your phone or computer and access it as needed to complete transactions quickly and easily.

How Do Digital Wallets Work?

Before you can use a digital wallet, you have to download or sign up for one. If you own an Apple, Google, or Samsung device, you likely have a native wallet app downloaded already. But you can also sign up for an online wallet offered by PayPal or  Square.

After you’ve signed up, it’s time to set up your authentication information. This may involve some combination of PINs, or typed passwords, as well as facial or fingerprint recognition.

Next, it’s onto your payment and account information. Typically, you can add your debit and credit cards, loyalty cards, and even bank accountsto your digital wallet.

The wallet will then encrypt your payment information to prevent anyone else from accessing your sensitive information.

Digital wallets also include Crypto Wallets that store cryptocurrency – more on those below.

How Can You Use a Digital Wallet?

Many people are familiar with the main purpose of digital wallets: to simplify the payment process. Depending on your preferred shopping method, this can occur in a few ways.

For instance, if you’re shopping at a store that permits contactless payments, all you have to do is hold your mobile device up to the point-of-sale system to complete the transaction.

Typically, this is no more complicated than using your thumb or face to unlock your wallet and authorize the payment.

Or if you prefer to browse online or in-app, you can use your digital wallet at checkout to minimize the number of times you streak through the house in your underwear searching for your elusive debit card.

Instead, you can select the appropriate wallet option in the payment screen and be on your merry way.

Even some ATMs now work with digital wallets to let you withdraw cash using stored debit card information. However, digital wallets aren’t just good for making payments anymore.

For instance, they can also help organize important documents and store easy-to-lose items like boarding passes, event tickets, gift cards, and coupons in one place.

Some wallets are even test-driving features in permissible states to store identification information, such as your driver’s license, as a legally acceptable alternative to physical ID.

Are Digital Wallets Safe?

Those who’ve held out on adopting digital wallets often cite safety and security among their hesitancies.

But as it turns out, digital wallets are actually safer than physical cards, as none of your information is stored within the wallet. Unlike your real wallet, which holds the actual cards themselves.

Three specific features contribute to this enhanced security: encryption, tokenization, and verification.

Encryption is the first step in protecting your information. Simply put, when you add information to your wallet, the algorithm then converts the data into a unique code only accessible by authorized entities.

Then, your wallet tokenizes the data by taking the encrypted information and replacing it with a token, or non-sensitive digital representation.

Every time you make a payment, your wallet randomly generates a new token from your encrypted data, which the merchant’s system then matches to accept your money.

Lastly, mobile wallets require verification to authorize a payment, such as your PIN, face ID, or fingerprint ID.

This combination of safety measures ensures that, even if a hacker got their hands on your information, the data would be effectively useless.

And if your device is stolen, your payment information is still safely locked behind your verification protocols.

Examples of Digital Wallets

Whereas not that long ago digital wallets were a novel idea, now, they’ve become commonplace.

For instance, if you’ve heard of Venmo, Apple Pay, Google Pay, Cash App, or PayPal, then you’re already familiar with four of the most common digital wallets out there.

Many smartwatch makers, such as Fitbit and Garmin, also offer built-in digital wallets for on-the-go payments.

Additionally, a number of companies offer online experiences and mobile apps with built-in digital wallets.

These not only store payment data, but also offer incentives and rewards programs to encourage online ordering.

If you’ve ever used the Starbucks or McDonalds apps to buy your favorite frappe, then you’ve taken advantage of these digital wallets, too.

Digital Wallets and Cryptocurrency

There is also a specialized type of digital wallet, known as a crypto wallet, that focuses on storing and transacting with cryptocurrencies.

But these items are less like wallets and more like an “address” that securely holds your bitcoin, ETH, and other crypto coins until you’re ready to spend them.

While a digital wallet is basically a convenience, crypto wallets are essential to the crypto process if you plan to send or receive money.

What are the Advantages to Using Digital Wallets?

Digital wallets boast several advantages over traditional wallets, such as:

  • Convenience and ease of access
  • Enhanced security via encryption, tokenization, and verification
  • Enormous storage capacity for payment details, event tickets, rewards cards, and even boarding passes
  • Easy, customizable organization
  • No physical bank account required, improving access for underserved communities

What are the Disadvantages to Using Digital Wallets?

However, digital wallets carry some unique downsides as well, such as:

  • Privacy concerns as companies can skim your purchasing habits to market to you
  • Not all in-person retailers have the technology to accept digital payments
  • Most states don’t allow you to carry your ID in your digital wallet, which means you still need a physical wallet, too
  • Your mobile device may run out of charge
  • A slight security risk if your wallet isn’t properly protected
  • Payment charges for some transactions (usually 1-3% of the transaction total)

Bottom Line: What is a Digital Wallet?

Digital wallets offer convenience, efficiency, and security that physical wallets just can’t match.

And with virtual and contactless commerce growing more popular, it’s only a matter of time before they’re just as common – if not more so – than the wallet in your pocket.

Andrew Ely
Andrew Ely

Andrew is a SimpleMoneyLyfe Editor & Data Analyst living and working in Southern California. Andrew brings previous experience editing, fact-checking, and analyzing data for a myriad of financial brands. When he isn’t editing you can find Andrew listening to podcasts and studying developing financial markets and trends that will shape the ever-changing world. Andrew’s areas of expertise are investing, domestic and international financial markets, and cryptocurrency.