The Reserve Bank says household borrowing is growing faster than incomes and New Zealand households are getting near to levels of indebtedness not seen since just after the global financial crisis.
In its latest Financial Stability Report, the central bank says rising house prices, high levels of mortgage debt, and the impact of a downward correction in property prices is the biggest risk to the country's financial system.
The higher house prices are, the more pain will be felt if there is a shock to the financial system which pushes prices down.
The central bank says an easing in bank-lending standards, with more banks prepared to lend more money to people with smaller deposits, and low interest rates, has fuelled demand and therefore rapid house price inflation.
Nationwide, annual house price inflation is at 9.8%, and the Reserve Bank says this is from levels that already appeared high relative to incomes and rent.
And on average, household debt is now 146% of disposable income, not much below the 153% peak it reached as the financial crisis began.
The Reserve Bank has clearly signalled interest rates are on the way up, and Governor Graeme Wheeler says borrowers may find servicing their debt difficult.
He says there are some house owners who have never experienced downward adjustments in house prices and increases in interest rates and many people expect house prices to continue to rise.
Mr Wheeler says the Reserve Bank has signalled in its monetary policy statement that it expects to increase interest rates given the strength of the economy and what's expected in the next 18 months or so.
"Those interest rates will certainly raise the debt servicing costs and especially affect those that have low equity."
Stability report didn't provide much 'new information'
An economist says the Reserve Bank's Financial Stability Report didn't provide much in the way of new information.
Last month, bank mortgage lending restrictions to people with deposits of less than 20% (loan to value ratio restrictions or LVR) were introduced.
House prices are continuing to rise, while builders argue the restrictions on bank mortgage lending to people with deposits of less than 20%, which came into effect on 1 October, have choked off a much needed lift in house building.
First NZ Capital's director of economics and strategy Chris Green says the major news was the central bank's initial assessment that lending restrictions were beginning to have an impact on market behaviour.
Mr Green says the key factor for him was that the Reserve Bank seemed reasonably comfortable at this point in terms of the impact of the LVR mortgages on the housing market, even though it's still early days.
He says the report noted that it was early days but said there were initial indications in mortgage approvals of some softening, as well as referring to anecdotal reports of dampening activities in the housing market as a result.
