Making it easier for home buyers to borrow more than they can reasonably service does "nobody a favour", the Reserve Bank of Australia has warned.
As interest rates have fallen, demand from housing investors and trade-up buyers has increased. But first home buyers will feel squeezed out, which is "probably quite disheartening" for them, head of the RBA's financial stability department Luci Ellis told a Sydney conference.
"As such, it would not be a good outcome if they responded by overstretching themselves to try to get into the market during upswings," Ms Ellis told the CITI Residential Housing Conference.
"As well as being against first home buyers' own long-run interests, that would increase risk in the financial system."
Overseas experience has shown that making excessive borrowing easier is unhelpful, she said.
Ms Ellis also warned that if housing prices in large cities rise rise too high for some residents, smaller cities cannot provide viable alternative locations as their rates of employment growth are slower.
In recent years, smaller cities' rates of employment growth have been below those of inner-city areas, where job growth is mostly concentrated, she said.
At this rate, it will be hard for smaller cities to catch up with larger ones, Ms Ellis said.
This means small cities are unable to offer the variety of job opportunities that would attract large numbers of former city dwellers, she said.