The housing market could collapse if mortgage rates rise to 7 percent, given the increasing numbers of households heavily in debt, the Reserve Bank says.
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The Reserve Bank stress-tested the ability of borrowers to cope with mortgage rates at 7 percent, which is close to the average two-year mortgage rate over the past decade.
It found 4 percent of all borrowers, and 5 percent of recent ones, would be put under severe stress where they could not meet day-to-day bills for food and power.
Auckland borrowers appear particularly vulnerable to higher rates, with 5 percent estimated to face severe stress.
"I could certainly imagine a situation where you're starting to see some significant decline in house prices in part of a city that start to have broader contagion effects elsewhere," Reserve Bank Governor Graeme Wheeler said.
Mr Wheeler's deputy, Grant Spencer, agreed it could send the housing market into a downturn.
"If you look at any market or banking collapse, if you start to get numbers over 5 percent it tends to have systemic effects and serious effects," Mr Spencer said.
A further 2 percent of all borrowers and 7 percent of recent ones would only have a small buffer for discretionary spending after meeting their mortgage payments and essential expenses, which the Reserve Bank described as "mild stress".
Reserve Bank head of macro finance Bernard Hodgetts said even mild stress could have a knock on effect.
"Those effects, clearly, do have the potential to accumulate."
The central bank also conducted the test at a 9 percent mortgage rate, which showed 7 percent of all borrowers and 18 percent of recent borrowers expected to face severe stress.
The Reserve Bank wants to introduce debt-to-income (DTI) restrictions, to help protect banks against the risk of default in a downturn.
"So that if a downturn comes, you don't get a whole lot of forced sales coming onto the market that depresses house prices even further, and create a risk for the banking system and also the broader economy."