What is Bitcoin And How Does It Really Work: An Easy To Understand Guide

You’re here because you are wondering what the heck is bitcoin and how it even works. You’ve heard it talked about on social media, in the news, and maybe from some of your friends. What’s all the hype about and should you be buying it? 

Well, keep reading because, in this article, you will know exactly what bitcoin is and why it’s created such a stir. If you’ve read articles before or watched videos that left you confused, don’t worry. I’m going to explain how Bitcoin works in the simplest terms, that a high schooler would understand.

Why explain it in this way? Well, when I tried to wrap my head around what is bitcoin and how it works, I was massively confused because no one could explain it in a way that was easily digestible. I want to explain it so you walk away feeling like you finally understand what bitcoin is and that you know more than you did 5 minutes ago.

Financial disclosure: this content is for informational purposes only and is not to be considered professional advice.

What is Bitcoin?

To put it simply, Bitcoin is a digital currency (aka money) that can be sent securely between any two people in the world.

You could end it right here because that is at its core what we call Bitcoin. But we will elaborate further.

Bitcoin is two things: both a currency and a payment system. Bitcoin is the digital currency that can be bought, sold, and transferred. Bitcoin is also the name of the network (aka system) used to buy sell and transfer the Bitcoin. 

Think of it this way: US dollars are used to buy things or sent between two people, but we need a network to do that. Usually, it is a bank or payment system like Venmo or Cash app. Bitcoin is money and has its own Venmo/ Cash app.

Bitcoin is decentralized

When we talk about the basics of Bitcoin, one key characteristic we must mention is that it is decentralized. 

What does this mean? In order for this to make sense, we first must talk about how our current money system is the opposite: it is centralized. 

In this context, centralized means power is controlled by authority aka the government. In our current money system, our cash is controlled by the central banks and government. Your bank has rules about how you transact with your money and how much interest your savings account earns. If you want to send large amounts of cash, let’s say $10,000+ to someone it must be recorded in a separate file the bank must keep a record of.  Central banks and the government work together to decide when to raise and lower interest rates on loans. They decide when to print money and how much gets introduced to the money supply, which lowers the purchasing power of the current dollars in circulation. Like the ones in your bank account, which means reducing your purchasing power to buy your everyday goods. These are examples of how the government controls our money system in a centralized way.

Bitcoin, on the other hand, is decentralized. It’s not controlled by any one person. It relies on the network, which is made up of everyone who uses Bitcoin, to make decisions. In order to make changes, everyone must agree. Bitcoin’s decentralized nature is a huge benefit to anyone who uses it because it gives everyone who uses it the power to control their own money. 

If you want to send Bitcoin to someone halfway across the world, you do not need a bank to do it. It can be done 24/7. Since there is a limited amount of Bitcoin, 21 million to be exact, its value can never be diluted, unlike regular money. Instead of storing your money at a bank, your store and hold your own Bitcoin, which I will talk about more in a bit. The government can never seize your assets for any reason because you control them. Bitcoin’s decentralization puts you in the driver’s seat of your money.

Is Bitcoin real money?

How do we know this Bitcoin isn’t just some fake monopoly money? To answer the question is Bitcoin real money, we first have to chat about what real money is.

Real money, as defined by Merriam-Websters dictionary, is something generally accepted as a medium of exchange, a measure of value, or a means of payment. I like Investopedia’s definition better because it’s more descriptive: money is an economic unit that functions as a generally recognized medium of exchange for transactional purposes in an economy.

It might seem crazy to think of, but people used to use all kinds of currencies as money such as salt, beads, and alcohol. Imagine going to Target to buy a new sweater and paying for it with beads! 

Bitcoin, just like beads back in the day, is an economic unit that functions as a recognized medium of exchange, for transactional purposes in our current economy.

Bitcoin is seeing much adoption from not just everyday investors like you and me, but big businesses are buying bitcoin like Telsa for example. Paypal now allows you to buy Bitcoin and hold it in your account. Institutional investors, aka the big guys who manage hedge funds, have recently started buying bitcoin because it has the greatest return on any asset in history. Safe to say, Bitcoin is real money.

Who created Bitcoin?

We cannot talk about Bitcoin and how it works without talking about who created Bitcoin. The creator of Bitcoin is a person, or possibly a group of people, named Satoshi Nakamoto,  who created Bitcoin in 2008. This person chooses to stay anonymous, and although many claims have been made about their real identity, no one really knows for sure. They currently own 1 million bitcoins, and at the time of this writing, this is valued at 41 billion dollars. Surely, for security reasons, it is easy to see why they might want to keep their identity anonymous.

He’s like the Batman of crypto.

Why do we need Bitcoin?

Now you may be thinking, so what? We have our own money already why do we need Bitcoin? This question could easily prompt a series of articles, but it’s important to point out that there are major flaws within our current money system. There are 3 big issues with our current money system: inflation, centralization, and counterfeit money. Bitcoin was created to be the solution for all three problems with our modern money.

Bitcoin is a hedge for inflation

Dollar bills, if you are in the US, are losing their value because the government is printing money and causing inflation. This is why things like gas, rent, clothes, and travel seem like they’re becoming more expensive. The value of our dollar is not going as far. 

With bitcoin having a fixed supply of 21 million, it is a limited supply that cannot be diluted. This means that no one can say they want to ‘print’ 1 million new bitcoins into circulation and devalue the currency.  Bitcoin’s fixed supply preserves its value. 

Verify authentic money from counterfeit

With paper money, there are tons of counterfeit bills circulating through people and businesses every day. There are tools to try to prevent accepting counterfeits bills like money counting machines and marker pens at cash registers, but even with those tools, counterfeit money still slips through the cracks. And the person left holding the counterfeit bill unknowingly gets the short end of the stick.

With Bitcoin, however, because each transaction is verified and stored on the blockchain, anyone who wants to see the history of transactions can look at the public ledger. Since all computers in the Bitcoin network have access to the same information, it can easily suss out when a counterfeit transaction tries to make its way into the public record. They wouldn’t be able to agree on the source of the transaction and would throw it out of the validation process as a result.

Eliminates the need for centralization

Since bitcoin transitions are verified on its own peer-to-peer network, it eliminates the need to trust the government or banks to hold and protect our money. Its decentralized nature gives people the power to have control over their own financial life. You can manage your money however you like and you don’t report to anyone how you choose to spend your bitcoin.

How does Bitcoin work exactly?

Traditional money goes through a central payment processor like your credit card company, but bitcoin is processed through a large network of computers running special software. So whenever a transaction occurs, like say you buy something with your bitcoin or you send it to someone else, both the sender and receiver’s bitcoin address and the amount is recorded on a public ledger also known as the blockchain.

 I like to think of a ledger like this – every time you checked a book out of the library it was stamped with the date it’s checked out. You can see it, everyone else who checks out that book can see the record: when it’s been checked out and how often. Bitcoin transactions are recorded like this but instead of inside library books, it’s stored in the blockchain.

How a Bitcoin transaction works

 Let’s say I send .005 bitcoin (at the time of writing this is $156.64) to my sister. This is considered a bitcoin transaction. Every transaction made with bitcoin is sent to all computers that process bitcoin. These transactions are encrypted using cryptography and verified by computers that all share exact copies of the blockchain. The end goal is to get the transaction recorded. Since every computer has the same copies it is impossible to make fake transactions.

The network of computers works together to record it on the blockchain. Transactions are grouped together, into what are called blocks, which are only accepted into the network if it hashed. What is hashing? This is a very complicated process, but what you need to know is that computers that run complicated software are running mathematical problems looking for a specific solution: the hash. There is only one hash to each block, sort of like how there is only one correct password to your accounts. 

The people who operate these computers are known as crypto miners and compete to find the specific solution aka the hash, to every block. The computer that correctly finds the solution finds the hash. When the hash is found, the recording part of the process is complete and those transactions are added to the blockchain. 

The crypto-miner is also rewarded for his work and is paid in Bitcoin for their participation in the process.

How does Bitcoin make money? 

Each time a bitcoin miner finds the hash and verifies the transactions, a bitcoin is created.  The price of Bitcoin fluctuates daily. Whatever people are willing to pay for bitcoin is its price. The same thing applies to things like gold and oil – it is determined by the market.

Can you convert Bitcoin to cash?

You can easily convert Bitcoin to cash whenever you want, and you don’t need a bank to do it. It’s a pretty simple process that can be done in minutes. If you hold Bitcoin you can convert your bitcoin to cash in a few different ways. 

Sell using a third-party exchange – You can sell your bitcoin via a third-party exchange like Coinbase or Blockfi. You can transfer your bitcoin from its current wallet onto the exchange and sell it for cash. This is the quickest process with low fees. For this reason, it’s one of the most popular ways to convert bitcoin to cash.

Use a Bitcoin ATM– Another option is to use a bitcoin ATM. Just like a regular ATM where you withdraw money, there are many bitcoin ATMs across the globe. They can typically be found at gas stations. Not all Bitcoin ATMs allow you to sell but some do so be sure to check your specific ATM. Something to keep in mind is the biggest drawback with Bitcoin ATMs is their fees. They are typically very high, between 7%-15%. 

Peer-to-peer transaction – you can sell your bitcoin for cash to a person directly using a platform like Local Bitcoins. You can choose how you want to receive your money for example via PayPal, or bank transfer. You gather some information about the buyer and if you two agree, your bitcoin is held in escrow until you receive payment. This is a great way to sell your bitcoin for cash and provides an alternative to selling through a third-party exchange.

How do you get started with Bitcoin?

Now that we’ve answered the question of what is bitcoin and how it works, we can now talk about how to get started with bitcoin.

Find a wallet to store your bitcoin

Before purchasing your first bitcoin, you want to choose a wallet to store your crypto in. Just like a regular wallet where you store your debit cards and cash to keep them safely stored, your bitcoin will need a wallet as well.

There are a few different types of wallets, but there are two major ones: hot wallets and cold wallets.

The major difference between a hot wallet and a cold wallet is security. A hot wallet is connected to the internet, and most exchanges that hold crypto-like Coinbase and Blockfi are hot wallets. A crypto wallet connected to the internet is vulnerable to attacks from hackers. A cold wallet is more secure because it’s offline. 

Hot wallets make your bitcoin easy to access and trade with and are free or inexpensive.

Cold wallets are safer and best used when you want to hold large amounts of crypto. They cost about $80-$150 so they’re a bit pricier than a hot wallet. Trezor and Ledger are the two most popular cold wallets.

Each wallet type has its pros and cons, you want to decide which one is best for you.

Purchase your Bitcoin

The next step is to purchase your bitcoin. It can feel intimidating when you try it for the first time, but buying bitcoin is a really easy and quick process.

The quickest and easiest way to purchase bitcoin for the first time is through a cryptocurrency exchange like Coinbase, Kraken, Crypto.com, and Blockfi.

There are other ways to buy bitcoin, like through a peer-to-peer network such as Local Bitcoins, but it’s recommended to go with an exchange for your first purchase. 

Once you decide on the crypto exchange you want to purchase your Bitcoin from, you will want to sign up for that platform. You will provide basic information, your bank account, and or credit/card information as your payment method.

You will want to keep in mind that there are different fees for various payment methods, and each platform will have its own fee structure. Take that into consideration when choosing the best exchange for you.

Next, you’ll want to select the amount you want to purchase. You can start small with something like  $5, you don’t have to buy a lot and can work always your way up to larger purchases.

Once you make your purchase, the last step is securing your bitcoin into your wallet. If you want to start with a hot wallet and you purchased your Bitcoin from an exchange like Coinbase, you can keep your bitcoin in one place. Coinbase is an exchange and also offers a hot wallet service to store your bitcoin. I recommend starting with Coinbase for this reason – it’s beginner-friendly and convenient. 

Is Bitcoin an investment?

Bitcoin can be considered a long-term investment as it is the first and original digital currency. Its value is expected and designed to increase over time. With big investors on Wall Street beginning to adopt it and governments coming in to regulate the crypto space, its staying power is only increasing. The more people who become familiar with Bitcoin and understand its value and potential the more people will buy it for themselves. And with more demand, and a fixed supply, the value of Bitcoin will increase.

What are the downsides to Bitcoin?

Bitcoin is not without its flaws. First, bitcoin is very volatile. Unlike the stock market, bitcoin has had some pretty heavy price swings.  In December 2017 Bitcoin’s price reached a new all-time high of $19,783 22 and 5 days later Bitcoin fell below $11,000 for a 45% decline. 

Second, it’s largely unregulated by the government right now. This leaves a lot of uncertainty surrounding the types of restrictions they will set on bitcoin.

Thirdly, it’s not a widely accepted form of payment. There are many places you can pay with bitcoin but you can’t exactly pay for your Starbucks with it yet. 

And fourth, any transaction made with bitcoin is permanent. It can never be reversed, so users making payments with bitcoin must be very careful and be absolutely sure of the transactions they make.

Is bitcoin worth it?

If you believe in the power of decentralizing your money to take full control of your financial life, then you will find that bitcoin is worth it.

Bitcoin aims to solve the biggest issues with our current money system: inflation, centralization, and authenticity. No other money system has come close. 

Bitcoin has the power to disrupt our entire monetary policy, it can change the way we do business and live our everyday lives forever by giving everyday people like me and you a chance to keep our money from being tampered with and diluted while also giving us the chance to store and build our wealth. 

With bitcoin’s 21 million fixed supply, there will never be any more bitcoins. The government does not have the power to create bitcoins whenever they want. Because bitcoin is pseudo-anonymous, anyone can hold bitcoin. The government cannot seize your assets on demand. It’s yours and yours to keep.

As bitcoin’s demand and adoption continue, its value will increase over time. Anyone who invests in bitcoin will be in for a bumpy ride with its volatile nature, but those who stick it through time and patience will be rewarded.

What is Bitcoin And How Does It Really Work: Is it worth it?