After you've worked your way out of debt, built up an emergency fund and insured yourself, you might want to think about buying a home.
For the most part, it's hard to go wrong investing in your own home. Residential real estate has shown annual returns of about 10 percent in the 1970s and early 1980s, although returns have cooled over the last 10 years.
Home ownership also has tax advantages. The mortgage interest you pay is tax deductible, thus lowering your federal tax bill. And when you sell your existing home and trade up to a more expensive one, you can defer the capital gains on the sale of the first house.
And finally, when your kids have flown the coop and you're ready to retire to a smaller home, you can sell your large old home and completely exclude up to $125,000 in capital gains. Better yet, there's even talk about eliminating all capital gains taxes on home sales.
But these tax advantages are well known, and this drives up the cost of housing beyond what it would be otherwise. And besides, if you only want tax-deductible interest, you can get all you want by deducting investment interest which I describe in my tape on tax planning.
Although residential real estate was a great investment in the 1970s and 1980s, it's doubtful that this trend will continue, at least on a national scale. The reason is the baby boomers.
The baby boomers entered their 20s and 30s in the 1970s. This created a large demand for homes, and drove up home prices. This continued in the 1980s as the boomers moved into bigger homes.
But now the boomers have their homes, and the demand for housing has dropped. We're already seeing the effects of this.
Housing prices in California and the northeast already have come off their highs, and the country as a whole has seen housing prices appreciate only modestly in recent years.
Also remember that it's not the end of the world if you decide to rent your housing. Usually you can rent for less than you'd pay to buy comparable housing.
And remember that even if you buy a home, you're still renting. When you take out a mortgage, you're renting money. For some reason people feel that they need to buy a home because a having home is better than having a bunch of rental receipts at the end of 30 years.
This may be true, but since you can usually rent for less than you can buy, you can take the money you're saving by renting and invest in securities which may appreciate faster than real estate.
So if you rented and invested the difference, at the end of 30 years you'd have a pile of rent receipts and a large portfolio of stocks, while your house-buying friend would have a pile of mortgage interest receipts and a house. The difference doesn't seem that large when phrased this way.
But saving and investing takes discipline, while a mortgage forces you to invest in your home. Also remember that if you're a home owner, your cost of housing will remain fairly stable, whereas renters will have to pay more as inflation creeps up. And even if you don't own a home for whatever reason, you probably should invest some money in real estate, perhaps through a real estate mutual fund.
So if you want to buy a house, go ahead, but don't expect to get rich quick, and be wary of buying a large, expensive home. You can currently deduct mortgage interest payments for mortgages up to $1.1 million, but this figure could fall to $500,000 or it may be eliminated completely under a flat tax. By losing their ability to shelter income, prices on expensive homes will fall.