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 [ref].
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.
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:

Methods of withdrawing funds from a PayPal account

In the next section, we'll see what it takes to get yourself 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.

Get verified to move funds between your bank account and your PayPal 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.
In the next section, we'll discuss PayPal's 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 [ref]. 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.
Next, we'll learn about the history of PayPal.

Security After a series of scams, PayPal formulated a plan to prevent criminals from using computer programs to open dozens of fraudulent accounts with stolen credit card numbers. This system, known as the "Gausebeck-Levchin" test, is now widely used by thousands of Web sites [ref]. It requires new account creators to type in a word found in a small image file on the account creation page. A script or a bot can't read this word -- only a human can decipher it. The Gausebeck-Levchin test on PayPal: The sight-impaired (who use text-based Web browsers) can listen to a recording of the letters instead. PayPal also uses special programs to detect potentially fraudulent activity. These programs watch for certain red flags that might be a sign of fraud. These red flags include sudden increases in volume or quantity of transfers, denied credit card charges or invalid IP addresses.

Peter Thiel and Max Levchin founded PayPal in 1999 under the name Confinity. The idealistic vision of the company was one of a borderless currency free from governmental controls. 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 attorney generals 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.

PayPal's Auction Tools page for eBay sellers.

Despite the initial turmoil, PayPal's market share continued to grow. At first PayPal offered new users $10 to join, plus bonuses for referring friends. The service grew so quickly that it soon became the default online payment service. Buyers wanted to use it since so many merchants accepted it, and merchants accepted it because so many buyers were using it. PayPal owes much of its initial growth to eBay users who used the service to pay for items and accept payments 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 2002, eBay bought PayPal. Then it phased out Billpoint and integrated PayPal into its services. Sellers with PayPal accounts can place icons in their auctions and buyers can simply click on a PayPal logo when they win an auction to make an immediate payment.
In early 2002, PayPal held its IPO, opening at $15.41 per share and closing the day's trading above the $20 mark [ref]. eBay purchased PayPal that same year for $1.4 billion in stock [ref]. Recently, eBay spent another $370 million to buy out another PayPal competitor, VeriSign.
In the next section, we'll learn about the different types of PayPal accounts.


The three PayPal account types differ in some important ways. All have access to PayPal's core features, which include:

• Send Money
• Request Money
• Auction Tools
• Website Payments
• 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.
Next, we'll check out some different ways to use PayPal to make payments.

Sending Limits One confusing part of PayPal is the sending limit that they place on new accounts. These limits are typically $2,000 for new users, but sometimes users outside of the United States can't use the account to send money at all until they go through a verification process that lifts the limit. It's a lifetime limit -- once you hit that level, you can no longer send until you verify the account. However, the limits aren't consistent and some transactions don't count towards the limit. PayPal's user agreement does not make clear when or why the limits change, or what charges don't count towards the limit.

More than 70 percent of all eBay sellers offer PayPal as a payment option, and a large chunk of PayPal's business still comes from online auctions [ref]. However, one of the keys to PayPal's success has been its ability to expand beyond the eBay 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.

The PayPal Shops page includes online merchants that accept PayPal.

You can use PayPal to purchase goods from non-eBay merchants who have set up a PayPal storefront. Once you've selected your items, go to the Web site's checkout page. You will have the option of selecting a credit card or PayPal to pay for your purchase. Selecting PayPal may send you to a login page for your PayPal account. There you can transfer the appropriate amount to the merchant, who will then complete the sale. Some merchants integrate PayPal into the Web site, meaning that you put your PayPal information directly into their site.

Just click on the PayPal button to use it as a payment method.

If a Web site only accepts credit cards, you can still use funds in your PayPal account to make a purchase. PayPal users can use the "PayPal Debit Bar" to get a virtual MasterCard number. 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.
For example, you might want to use your PayPal account to buy something from Amazon.com. However, Amazon doesn't accept PayPal as a payment method. You can activate the Debit Bar from within your PayPal account. Assuming you are carrying enough of a balance in your account to cover the purchase, PayPal will give you a 16-digit number, just like a credit card number. Then you will select MasterCard as your payment method from Amazon's payment page and enter the Debit Bar number.
In the next section, we'll see how merchants can use PayPal to accept payments.


Merchants who want to use PayPal to accept payments have a wide range of options available. For basic payments, such as online auctions or simple Web site sales, the merchant can simply provide buyers with their e-mail address, and buyers can make the appropriate payments to the merchant's PayPal account. eBay sellers can place PayPal buttons on their auctions, and the checkout invoice PayPal sends to auction winners will include a link to pay via PayPal.

You can use PayPal to request money from anyone.

PayPal also provides extensive services for online merchants. Prior to services like PayPal, someone who wanted to accept credit card payments online had to set up a merchant account through a credit card company. Creating a Web interface to use this account could be confusing and difficult. PayPal bypasses this problem. Business or Premier PayPal accounts can set up a Buy Now button, a PayPal shopping cart, or options for ongoing subscriptions and recurring payments.
A Buy Now button allows merchants to paste a small piece of HTML code into their site, creating a button for buyers to click when they want to purchase an item. This takes the buyer to a secure payment page, where they enter their credit card information and shipping address. Once the transaction is complete, the money, minus PayPal's fees, is transferred directly into the merchant's account.
The PayPal shopping cart is more involved, but it has the same result. HTML code for various buttons (add to cart, view cart) is added to lists of items, and the item details are added by the merchant. Buyers can add the items they want to purchase to their cart, and when they check out, they'll go to a secure payment page, just like a Buy It Now page.

The transaction process for a Standard Merchant account

PayPal's two main merchant account types, Standard and Pro, offer slightly different packages. With a standard account, when a customer checks out at the shopping cart page, they go to the PayPal site to log in and make the payment. With a Pro account, PayPal processes the transaction in the background -- the customer makes the entire sale on the merchant's site. A Pro account has higher percentages on transactions (2.2 to 2.9 percent versus 1.9 to 2.9 percent) and a $20 monthly fee. It also requires knowledge of Web services and APIs (Application Program Interfaces), as well as a minimum of two days for installation.

The transaction process for a Pro Merchant account

PayPal also streamlines transactions for merchants who sell to international users. It can convert funds to whatever currency the merchant wants for 2.5 percent. Currently, PayPal accepts funds in the following currencies:

• Canadian Dollar
• Euro
• Pound Sterling
• U.S. Dollar
• Yen
• Australian Dollar

Next, we'll find out why some people refuse to use PayPal.

Money Market Fund The only way for PayPal users to make money on their own funds is to apply for its money market fund. Unlike money market accounts, money market funds are not insured by the FDIC. Learn more here.

Not every PayPal user has come away satisfied with the company's business practices. In fact, so many people feel the company has abused them that entire Web sites exist to discuss problems with PayPal. The most prominent is PayPal Sucks. The biggest criticism of PayPal is that it acts like a bank, but it isn't regulated like one. This means 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 [ref]. 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.
I had my PayPal account frozen with about $50 in it in 2003. Apparently, a change of address caused a red flag that led to the account freeze, although I followed the proper steps for changing the address on the account. A phone call to PayPal customer service resulted in a sudden unfreezing of the account.
Reports by former PayPal employees indicate that this freezing and unfreezing is arbitrary and not subject to any serious scrutiny. They also claim that company executives look at this process as a revenue stream. Some feel that PayPal intends to make money to cover losses due to fraud by seizing funds from customer accounts [ref].
You can find a thorough and open-minded (if slightly outdated) examination of various complaints against PayPal here. Other charges levied against PayPal include:

• Lax security, despite their claims as a secure method of making online transactions
• A long and confusing Terms of Service Agreement that tricks users into giving up both their right to sue the company and their protections under credit card laws
• Rude customer service representatives
• Poor hiring practices that have led to a number of scams committed as "inside jobs"