People are becoming accustomed to hailing cabs, reserving hotel rooms and video chatting with family and friends using their smartphones. So it only makes sense to pay for groceries, movie tickets and other purchases with a quick scan of a smartphone-based app called a digital wallet.

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But what is a digital wallet, and how does it work?

Types of Digital Wallets

First, it helps to understand that there are a few major categories of digital wallets: those offered by digital outlets like Apple, Samsung and Google, for example; those offered by major banks; and still others offered by individual merchants, in which you download their app to your device and you store payment credentials in the app to use for payments. These digital wallets work by storing your payment credentials either on your device or off the device on a server. At the point of sale, wallets such as Apple Pay can be used at any merchant that accepts Apple Pay, while merchant wallets can only be used at that merchant’s own stores.

As defined by Investopedia, a digital wallet “is a system that securely stores users’ payment information and passwords for numerous payment methods and websites.”

Digital wallets utilize near-field communication (NFC) technology that allow the user to complete purchases without actually touching the retailer’s payment device, according to NearFieldCommunication.org. A mobile wallet can also mean that fewer physical payment cards are needed, which may mean they’re less likely to be lost or stolen.

Given their convenience and enhanced security features, digital wallets are starting to gain traction among U.S. consumers. As of January 2017, 64 percent of U.S. smartphone users reported having made some sort of mobile payment, and 39 percent owned digital wallets, according to data from Statista. By the end of 2018, Apple expected its Apple Pay to be accepted at 60 percent of U.S. retail locations.

How Do Digital Wallets Work?

Paying with a digital wallet typically involves taking out your phone and simply holding it over or tapping a payment terminal — not so different from swiping or inserting your credit card. (This also may be called making a contactless payment.) If you have several different cards stored in your digital wallet, then tapping your device will initiate a prompt asking you to select the card you’d like to use.

Your smartphone then transmits your encrypted payment information and asks you to verify your purchase by entering a code, entering a pattern or taking your fingerprint. Once the user is verified, the transaction is carried out as if you had paid with a physical credit or debit card.

And a bonus to using digital wallets? Phone provider wallets may integrate with loyalty and rewards programs, and merchant wallets may let you buy and store gift cards, order and pay in advance, and even use coupons.

When using a digital wallet, the same good habits around security and responsible spending should apply as when you’re using a plastic card. Choose your “default” card carefully, and make sure that your usual sound financial behaviors follow you into cyberspace.

Are Digital Wallets Secure?

Because the information that is transmitted from a digital wallet is encrypted, a contactless payment can be more secure than using your physical charge card. Digital wallets use a combination of EMV technology and one-time “tokens.” This means that, with each transaction, your phone encrypts your information, which is taken by the terminal at checkout and then sent to the digital wallet provider, which decrypts the information, identifies you and then sends the request to the payment processor, that then requests the money from your bank.

Some people are concerned about what happens if their mobile device is lost or stolen. This is an area where two-factor authentication comes in handy. This extra layer of security asks for a one-time code, fingerprint or other authorization for each purchase. Have you updated your phone’s unlock code recently? You can keep your digital wallet secure using several of the same strategies you already use online: Do not give out your username or password. Be sure your internet access connections are secure and do not transact financial business over public Wi-Fi.

Your credit card issuer is also part of your security team, in the form of emails and alerts that help you stay on top of potential fraudulent activity. For example, you can typically request a text or email alert whenever a transaction is posted that is over a specific amount you specify, such as $100. Many credit card issuers, including Discover, offer $0 fraud liability for unauthorized card transactions, adding another layer of protection.

So, what is a digital wallet? It’s yet another way that your smartphone is taking over for an important tool in your life — first it came for your calendar and camera, and now it can even replace the plastic cards in your physical wallet.

Originally published March 22, 2017

Update March 22, 2019

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