Last week I wrote about the strange way we measure poverty in the United States. Canada doesn’t have a defined poverty level but instead uses a Low Income Cut Off or LICO. The LICO is a level of income below which a family ends up spending more of its income on necessities than an average family of the same size (this is a good rundown of poverty measures in Canada). 

The history of measuring poverty in the United States is not one that has inspired a great deal of confidence. There is a sense from advocates working on poverty issues that people above the established level are still poor, while others worry that setting the bar too high would incentivize poverty. Housing affordability measures have a similar story. A new way of looking at housing affordability called the residual income approach is one that offers a real alternative to the current method.

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  • For the better part of the last 100 years, housing affordability has been calculated as a ratio of housing cost to income on a monthly basis. The normative standard (that is, what a person should be paying) for housing affordability is 30 percent (or less) of monthly income. The 30 percent threshold started as a 25 percent threshold (a week’s wages for a month’s rent) and then crept up to 30 percent. This rule of thumb has been constant since 1981, and because the Department of Housing and Urban Development has used this standard it has dominated the field in terms of how affordability is determined.

    The problems with the 30 percent rule of thumb are pretty obvious. First, a person of means might spend well over 30 percent of their monthly budget on a mortgage or rent and still not be struggling to get by. A person who earns $500,000 per year and lives in Portland could easily spend $200,000 on housing and still be considered well-to-do. Secondly, on the opposite end of the spectrum, there are some families for whom even 20 percent of the monthly budget spent on housing creates a significant challenge—making for excruciating choices between food, childcare, healthcare, and other needs. And the 30 percent rule doesn’t account for regional differences. Prices for other necessities might be much higher in one area than another, throwing the whole thing off-kilter.

    But are there any better ideas out there? Yes and no. While housing advocates and academics alike have long expressed frustration with the 30 percent rule of thumb we haven’t yet seized on a silver bullet solution. Patches have been developed like pegging the rule to some percentage of Area Median Income (AMI). In Seattle, for example, the latest affordability debate has been over creating “work force housing” which would be affordable to people earning 80 percent of AMI. But this system has some of the same drawbacks and doesn’t really account for the other factors that drive where people live, like perceptions of school quality or public safety, both considerations which might influence residence in places where they might pay more for housing in exchange for better schools or safer streets.

    This summer, Sightline sent our intern, Avi Allison, on a mission to comb through the housing affordability literature to see if there were any good alternative approaches to setting a standard that works. This is where we came upon the residual income approach championed by Michael Stone of the University of Massachusetts-Boston. The residual income model is similar to the self-sufficiency standard  for considering poverty in that it looks at more than just income to determine what is affordable.

    The residual income model looks at how much money is left over after paying for housing and considers the costs of other basic necessities. Here is how Stone describes the concept:

    This means that a household has a housing affordability problem if it cannot meet its nonhousing needs at some basic level of adequacy after paying for housing. The appropriate indicator of the relationship between housing costs and incomes is thus the difference between them—the residual income left after paying for housing—rather than the ratio.

    Like the self-sufficiency measure, residual income adjusts for local factors and costs in a way that the 30 percent rule of thumb can’t. And, because it considers a basket of goods and services that families need in addition to housing, it addresses the problem of housing affordability more broadly. Here is Stone on the benefits of the approach.

    First, it offers a more precise and finely honed instrument for assessing housing needs and problems. Second, it points toward revisions in housing subsidy formulas that would result in a more equitable and efficient allocation of subsidies. And third, it suggests a way of refining residential mortgage underwriting that might perhaps yield a more accurate assessment of risk.

    But does this approach work? Well, Stone applied it to housing costs in the United Kingdom and found that if it were used there, some households that pay less than 25 percent of their monthly income on housing would qualify for a subsidy, while some households that pay more wouldn’t. He found that a critical factor was family size, with larger families, not surprisingly, having much higher expenses after housing costs, even if they paid less than 25 percent of income on housing.

    We’ll be doing more work to see how the residual income approach might fit together with the self-sufficiency standard for an even better whole-picture model. Understanding poverty and housing affordability in our region is the first step toward sustainable solutions.