The rate of house price growth in the Republic is set to slow to 3 per cent next year as rising interest rates make mortgages more expensive, a report by Bank of Ireland shows.

In its latest property review, the bank said yesterday the key challenge for the market is the rising interest rate environment.

The European Central Bank (ECB) raised rates in March for the second time in three months after five years without an increase. They now stand at 2.5 per cent. However, in the shorter term, Dan McLaughlin, the bank's chief economist, is forecasting house price growth of 9 per cent this year.

He said inflation may even exceed 13 per cent in the next few months despite record supply levels and the prospect of rising interest rates.

"So far in 2006 the Irish housing market remains vibrant," he said. "This is understandable given the strength of the Irish economy and the continued surge in employment."

The bank is also forecasting continued strength in mortgage lending this year, with growth of 12 per cent, or 110,000 mortgages.

Still, while the extended period of low interest rates means that mortgages are currently relatively affordable, any future rises could hurt this ratio.

Mr McLaughlin said affordability will be an issue as rates rise. This year, the bank is forecasting an affordability ratio - the annual cost of servicing a 25-year mortgage relative to average income - of 35 per cent, which will rise next year to 38 per cent, a number Mr McLaughlin believes will lead to a "substantial deceleration" in house price inflation.

The bank is forecasting a 1 per cent rise in rates by early 2007, bringing the popular standard variable tracker to 4.75 per cent.