What Is Bitcoin and How Does It Work?

What Is Bitcoin and How Does It Work? loading="lazy"

Bitcoin is the first and likely the most well-known example of a cryptocurrency—virtual money you can use to buy and sell goods and trade for cash. It launched in 2009, but Bitcoin didn't become a household name until around 2017. That's when it made headlines around the world as the price per bitcoin tripled in just a few weeks to nearly $20,000. Interest in the cryptocurrency generally waned as prices fell to under $3,500 within a year, but Bitcoin eventually came roaring back, and the underlying blockchain technology that allows it to work hasn't disappeared.

How Does Bitcoin Work?

Bitcoin is a decentralized and completely digital currency. Unlike fiat currencies, such as the U.S. dollar, euro or British pound, governments don't create or back bitcoins.

Bitcoin and other cryptocurrencies—there are many—are powered by "blockchain" technology. The Bitcoin blockchain is a decentralized public ledger, which might sound like technobabble, but isn't difficult to understand as a concept.

The Bitcoin blockchain is a public ledger (or database) that's created and managed by a large network of computers rather than a single entity or central bank—that's what makes it decentralized.

New information, such as recent transactions, are grouped together to form a block. The block is then added (or chained) to the existing database. Once new information is added, it can't be edited or deleted, and anyone can review the Bitcoin blockchain database. The result is a permanent record of Bitcoin transactions that's available for public review.

For example, if you send bitcoins to someone else, an uneditable record of the transaction is added to the ledger, which is synced on tens of thousands of computers around the world.

Bitcoin also allows for transactions that remain anonymous to a certain extent. While there's a public record of the transaction from person A to person B, there isn't any identifying information about who person A and B are. However, anonymity goes out the window if you publish your Bitcoin address (the address you use to receive the currency) publicly. With your Bitcoin address, someone can see your transactions and even view the balance associated with it.

All of this complex math requires a lot of computational power, which is where Bitcoin miners come in. Miners allow use of their computers to process transactions and, in return, they receive bitcoins as payment. Anyone can set their computer up to mine Bitcoin, although the cost of electricity to power your computer may be more than you earn in the currency.

Should I Buy Bitcoin?

In addition to earning bitcoin from mining, you can buy and sell it online. But before you do, consider why you want to own it and the risk involved.

You can use Bitcoin to send a payment to someone else, and some companies accept it as a form of payment. However, Bitcoin's volatile price doesn't make it an ideal currency for day-to-day transactions. After all, you don't want to spend $1,000 worth of bitcoin on a new computer to find out the same amount of bitcoin is worth $3,000 a few weeks later.

Instead, many people view the cryptocurrency as a store of value, similar to gold. While you can't pay for most purchases with gold, you may want to buy gold because you think it will be worth more later.

People have made money buying Bitcoin as an investment. However, as with other investments, there are risks, and people have also lost lots of money selling their bitcoins for less than they bought them for. Others lost their entire investment when the platform they used to purchase their bitcoin was hacked, and unfortunately there was no way to track down the hackers or get their investment back. Keep the high level of risk in mind as you consider whether to buy.

How to Buy Bitcoin

If you want to purchase bitcoin, the easiest way to do it is through an online exchange. Some popular options include Binance, Coinbase, Gemini and Kraken.

You can buy bitcoin on these platforms using different methods, such as a credit card, bank account or by trading other cryptocurrencies. There will likely be a fee for each transaction, and the price of bitcoin may vary slightly from one platform to another.

You'll also need a digital wallet when you buy bitcoin. Your bitcoins aren't technically stored in your wallet—they're part of the public Bitcoin blockchain. However, your digital wallet is where you keep your public and private key.

The public key can be shared with others and lets them send you bitcoin. Your private key should never be shared with anyone, because that's what lets you send bitcoin to others. It's a bit like a password to your online bank account. Other people can send you money if you give them your bank account number, but you're the only one who can log into your bank account to access the funds.

Many public platforms let you purchase, sell and transfer bitcoin, and create a digital wallet for you on the platform. Platforms generally simplify the process, and allow you to manage your cryptocurrency accounts with a user-friendly interface like you would many other online accounts. The safest way to store bitcoin, however, is to keep your private key hidden somewhere, such as a thumb drive or written down on a piece of paper.

What Is the Future of Bitcoin?

The blockchain technology that's the backbone of the Bitcoin network has many practical uses and may be adopted by different businesses in the future. Cryptocurrencies, in general, may also become more popular in the future. However, it's impossible to say if Bitcoin will remain the most popular cryptocurrency or if something else will take its place.

Alternatives Ways to Invest

If you want to begin investing with Bitcoin, you may want to limit your risk by starting small and putting just a small share of your overall portfolio in cryptocurrencies. Look to diversify your portfolio with additional investments, such as:

  • Stocks: When you buy stock, you're purchasing partial ownership in a company. The stock's value may increase as the value of the company increases, and some companies share part of their income with stockholders as dividends. However, stocks can also be a risky investment, and you could lose all your money if a company goes bankrupt.
  • Bonds: You can purchase corporate and government bonds, which are essentially loans to a company or government organization. As the lender, you can earn interest on the money you lend and receive the principal loan amount back at the end of the loan's term.
  • Mutual funds and exchange-traded funds (ETFs): If you want to quickly invest in many things with a single purchase, you can buy shares in a mutual fund or ETF. These funds can be made up of multiple stocks and bonds, or mirror the price of a collection of stocks or bonds.

There are many easy ways to start investing if you're brand new. You can open a brokerage account online or using a mobile app, fund the account with a bank transfer and then purchase investments. However, if you're investing for retirement, there may be tax advantages to using an individual retirement account or an employer-sponsored retirement plan, such as a 401(k).

Will Buying Bitcoin Impact Your Credit?

The money you keep in checking, savings or investment accounts doesn't impact your credit history or scores. Your income and overall net worth also doesn't factor into your credit. As a result, purchasing bitcoin won't affect your credit. However, if you buy a lot of bitcoin hoping to make a quick buck and then its value drops, you might find yourself unable to pay other bills—and missing those payments could hurt your credit. You might also run into credit trouble if purchasing bitcoin causes you to run up a high credit card balance that increases your credit utilization, and results in missed payments if you can't afford to pay it off.