"Significant pressure" will be placed on the ability of households to meet their debts as monthly payments on around 4 million mortgages are expected to increase over the next year.
The Bank of England said in its Financial Stability Report that economic conditions had deteriorated, with UK households being “stretched” by rising interest rates and soaring inflation.
"The risk that indebted households will default on loans, or sharply reduce their spending, has increased," the report said.
Still, despite the financial pressure arising from the cost of living crisis, the report said that UK households were not yet showing “widespread signs of financial difficulties”.
Four million households are to have more expensive mortgages next year and two million will have higher payments by the end of 2025, the BoE suggested.
People with a fixed-rate home loan due to expire at the end of 2023 are facing an increase in their average monthly repayments of around £250 because they will have to refinance onto a higher rate.
This could mean that costs surge by £3,000 a year for many households who are already seeing their finances stretched by increased living costs.
It warned tenants that landlords are likely to pass on the higher costs, with rents forecast to increase by around 20%. The report said: "This would increase the cost of housing for renters, which may affect their resilience."
Bank of England governor Andrew Bailey said the “economic environment is challenging” but stressed that households are better placed to deal with this than during the 2008 financial crisis.
He said: “We have high inflation, demand is slowing and interest rates have been rising.
“Household and business finances are under greater strain.
“Overall however, both households and businesses are more financially resilient than they were in previous periods of stress.”
Household spending on mortgage payments as a share of their income is expected to rise, but it will remain below previous peaks after the global financial crisis and the 1990s recession.
— Bank of England (@bankofengland) December 13, 2022
The increased pressure on households is not expected to challenge the resilience of UK banks which will be well equipped to support lending, the Bank’s Financial Policy Committee said.
This is because major banks and building societies have strong balance sheets, higher profits, and have increased their provisions to support credit losses, it said.
Investment funds and other non-bank financial institutions face their first 'stress test' next year as the Bank of England seeks to avoid a future pension fund crunch
The Bank’s Financial Policy Committee said that more work needs to be done to prevent non-banks posing a risk to UK financial stability, after gilt yields surged at historic rates in September and the Bank was forced to step in.
The BoE had to step in from September to buy £19.3bn ($23.73bn) of government bonds to stabilise markets following turmoil caused by the fiscal plans of Liz Truss's short-lived government.
The Pensions Regulator has been told to outline new buffer for the liability-driven investment (LDIs) funds.
Non-banks are defined as any financial institution that is not a bank, and includes pension funds and liability-driven investment (LDI) funds.
The FPC already stress tests the UK’s biggest banks to monitor their resilience against deteriorating economic conditions.
Watch: Watch: Will UK house prices ever fall?