of housing for program or policy design would require consideration of the total housing cost to a household, including any initial capital outlays.

# 3. Prevalent Approaches to Calculating Housing Affordability<sup>8</sup>

The most widely used approaches to calculating housing affordability are the expenditure-to-income ratio (EIR), the residual income method (RIM), the price-to-income ratio (PIR), and variations thereof.

## 3.1 Expenditure-to-Income Ratio

The most commonly used approach to measuring housing affordability at the _household level_ is the expenditure-to-income ratio (EIR), which is a ratio of housing expenses to the household income. The acceptable affordability threshold of the EIR ratio typically ranges between 20 to 40 percent across countries.<sup>9</sup> Normatively, this approach recognizes that if a household spends more than a certain portion of its income for housing, it will not have enough left for other essential expenses. The EIR approach is also often used by banks as part of their underwriting process<sup>10</sup> to evaluate the debt repayment capacity of a potential mortgagor (i.e., debt service ratio), and by government housing agencies as the basis for rent and subsidy calculations. Given the simplicity of the EIR measure, it is the most prevalent and commonly used indicator of affordability across markets.

Despite its widespread use, the EIR faces many criticisms. Stone (2004) notes that for low-income families, and many moderate-income families, paying 30 percent of their income for housing could leave them with insufficient money to meet other essential non-housing needs, while many high-income households can pay much more than 30 percent without any hardship. Moreover, Stone, Burke, and Ralston (2011) challenge the basic premise of the EIR which, rather than assessing whether or not a household’s housing costs draw on a reasonable share of one’s income compared to non-housing essential needs, assigns a predetermined percentage of income to the latter, even in cases where the income may be very low. They make the case that the rationale for the conventional standard has been built upon interpretations of empirical studies of what households _actually_ spent on housing in the past and that it should not be the norm for what people can be _expected to_ spend today.

> 8 Annex 2 summarizes several other, but less commonly used, measures of housing affordability that target specific characteristics of affordability.

> 9 According to Herbert, Hermann, and McCue (2017), “the 30 percent measure was first a 25 percent measure, derived from an old aphorism that one should devote ‘a week’s wages to a month’s rent,’ which, in turn, was based on studies that go back to at least the late 1800s of what typical families spent on housing. The rule of thumb began to find its way into housing policy beginning in the 1930s both as a measure of need and a guide for how much tenants should be expected to pay for housing.” In the US, the Brooke Amendment to the 1969 Housing and Urban Development Act codified 25 percent as the payment standard for public housing. In the 1980s, Congress increased this figure to 30 percent for most programs. According to HUD, a household paying more than 30 percent but less than 50 percent of its income on housing is considered housing cost-burdened and a household paying more than 50 percent of its income on housing is considered severely housing cost-burdened (Herbert, Hermann and McCue 2017).

The official Eurostat indicator for housing affordability is called ‘housing cost-overburden’, which is a housing cost-to-income ratio of 40 percent (Heylen 2018).

Australia uses a ‘30/40 rule’. The 30/40 rule defines facing a housing affordability problem as a situation where households in the lowest two quintiles (40 percent) of the equivalent disposable income distribution spend at least 30 percent of their gross income on housing (Gabriel et al. 2005).

10 Typically, in their decision to lend, banks use the EIR indicator in combination with other key underwriting drivers such as Loan to Value (LTV), credit score, loan amount, collateral quality and value, and consumer profile, among others.

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