"Take all your money out of noncollateralized investments and invest in my first lien mortgage investments," he writes, launching into a laundry list of reasons why his financial product is a lifesaver for risk-averse consumers. "Be bold," he concludes. "Fire your financial planner if they aren’t providing you a consistent 12% rate of return."

There are a lot of investments tied to real estate and mortgages these days, and each needs to be evaluated on its own merits. The first-lien mortgage program McDoniel is selling from his Encore Mortgage Advisors Corp. in Bedford, Texas, does have some positives, but it’s still going to be a Stupid Investment of the Week for the bulk of consumers who consider it.

Stupid Investment of the Week showcases the concerns and flaws that make an investment less than ideal for the average consumer, in the hope that spotlighting potential dangers in one situation make those troubles easier to root out elsewhere. The column is not intended to be an automatic sell signal, as there may be times when unloading a problem investment only serves to compound the trouble.

In the case of McDoniel’s first-lien mortgage-investment program, there clearly is potential for the investments to turn out right, but that hope for a good outcome is not enough for most investors to take the plunge. To see why that is, you must first understand how the Encore Mortgage program works.

McDoniel is a mortgage broker, and he is matching individuals with cash to real estate investors buying properties either in foreclosure or for the purpose of fixing up and flipping. As the person putting up the cash, you become the bank of choice for short-term deals being done by the would-be real estate magnates who use the no-money-down or buy-foreclosures systems discussed in late-night infomercials. (McDoniel says that the biggest surge of interest since the program started last year was after he presented it to a seminar audience hyping the investment programs of Robert Kiyosaki, author of "Rich Dad, Poor Dad.")

Because the program involves single mortgages on specific properties to one individual rather than a pool of investors the deals are not regulated and McDoniel is not functioning as an investment adviser. Of course, it is easy to overlook the potential problems of buying an unregulated investment because this is a mortgage, something almost everyone can understand.
To protect his borrowers, McDoniel says Encore Mortgage only does these deals to a dollar level where the loan equals just three-quarters of the lowest appraised value on the property.

The person making the loan is listed as the "loss payee" on the property’s insurance policy and the first lien is recorded in the lender’s name, making the property collateral for the deal. If the borrower winds up in default, the investor can foreclose, taking the property over at a price discounted to the appraised value.

Big return, concentrated risk

Best of all, McDoniel’s 4% commission is paid by the borrowers, who also agree to pay 12% interest to the lender putting up the dough. That 12% return is the big selling point, but it’s also where you can see this program start to unravel, because it’s nearly double most home-mortgage rates. "The typical house flipper is not paying anything close to 12%," says Greg McBride, senior editor at BankRate.com, "so you have to wonder who is paying [McDoniel’s] rates when there are so many more attractive options available. … If it’s only people who otherwise can’t get a loan, that could lead to foreclosure, which is not as simple as it sounds in his e-mail, and which can tie up your money — at no interest — for months."

That high rate of interest turns these deals into what amounts to a high-risk, callable bond. If buyers refinance, which is expected in 14 months or less, investors get their money back, whether they want it or not; if they can do another deal — generating another commission for McDoniel — they may be able to keep the cash flowing, but that is no given.

McDoniel noted that in the first deals he completed, a few wound up getting paid off early while the others have yet to get through the 14-month time frame; none have resulted in defaults. His average deal has been in the "high $100,000s." The investor must have that cash on hand to put it to work; using that huge chunk of dough for one investment could blow up the typical consumer’s conventional asset-allocation plan.

One positive for Encore is that the firm is only working on properties in Texas, where the rate of home appreciation has been more reasonable than in many other parts of the country. That means that a real estate bubble — the worry of property investors everywhere in recent years — would not be likely to hurt the Lone Star State quite as much as other parts of the country. But if the housing market is deteriorating, as most observers believe, it’s not a great time to flip properties, let alone use your cash to finance some other guy’s quick-turn strategy. The success rate for home-flippers is likely to decline over the next five years.

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