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The final installment of a loan to be paid in an amount that is disproportionately larger than the regular installment.
When a loan is made, repayment of the principal, which is the amount of the loan, plus the interest that is owed on it, is divided into installments due at regular intervals—for example, every month. The earlier installments are usually payment of interest and a minimal amount of principal, while the later installments are primarily principal. When a balloon payment is provided in a loan agreement there are a number of installments for the same small amount prior to the balloon payment.
People with irregular or seasonal sources of income find a balloon payment provision in a loan useful for budgeting their expenses. This is not the case, however, for the average consumer. Frequently, a consumer is persuaded to enter a loan agreement providing a balloon payment that otherwise would be unwise for her or him. The consumer underestimates the full effect that the balloon payment will have on his or her budget by focusing on the small amounts to be repaid during the early stages of the loan. It is not uncommon for a consumer to be unable to pay the balloon payment when it is due. The consumer is presented with a dilemma: either the consumer must return the item bought with the loan to the lender, thereby losing the money paid out in earlier installments, or the consumer can refinance by taking out an additional loan to use its proceeds to pay the balloon payment.
A balloon payment provision in a loan is not illegal per se. Federal and state legislatures have enacted various laws designed to protect consumers from being victimized by such a loan. The Federal Truth in Lending Act (15U.S.C.A. § 1601 et seq.) requires that a balloon payment—defined as an amount more than twice the size of a regularly scheduled equal installment—must be disclosed to the consumer. The consumer must be informed if refinancing is permitted and, if so, under what conditions. A creditor who fails to disclose such information can be held liable to the consumer for twice the amount of the finance charge, in addition to the costs incurred by the consumer in bringing a lawsuit. He or she can also be prosecuted and subject to a fine of up to $5,000, one year's imprisonment, or both.
Some states restrict the use of balloon payments to loans involving consumers with irregular or seasonal incomes. Those states that have enacted the provisions of the Uniform Consumer Credit Code do not limit the use of balloon payments, but they give the consumer the right to refinance the amount of such payment without penalty at terms no more than those in the original loan agreement.
A balloon note is the name given to a promissory note in which repayment involves a balloon payment. A balloon mortgage is a written instrument that exchanges real property as security for the repayment of a debt, the last installment of which is a balloon payment, frequently all the principal of the debt. Mortgages with balloon payment provisions are prohibited in some states.