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* Bank Negara may raise rates for first time in more than 3 years
* High household debt levels seen posing rising risk
* Central bank policy meeting on July 10 at 1000 GMT
By Trinna Leong
KUALA LUMPUR, July 7 (Reuters) - Malaysian car mechanic Cheong Tim Soong spent years trying to curb his dependence on expensive credit card debt until a friend took decisive action - cutting up the card in front of him.
Bank Negara, the central bank, is likely to take similar, though less drastic, action by raising interest rates on July 10 for the first time in more than three years, to curb strong domestic demand that has ratcheted up debt levels and inflation.
Consumer demand has underpinned healthy growth in recent years, making up for patches of weakness in exports, but much of it has been built on an expansion of credit that has also occurred in other Southeast Asian nations because of easy loans.
That has raised Malaysia's vulnerability to possible external shocks, such as a debt crisis in China or a sudden rise in U.S. interest rates. Research firm Oxford Economics said in a report last month that Malaysia's rising debt levels together with a high level of government bonds held by foreigners (around 45 percent) made it the "riskiest" economy in Southeast Asia.
"Malaysia's household debt is popping up on the radar screen but it's not at the breaking point at the moment," said Fred Neumann, head of Asia research at HSBC in Hong Kong.
"Bank Negara tried to use macroprudential measures to slow down the household debt and what they did was in line with many central banks. But an interest rate hike is often the most effective tool to slow down debt."
The "macroprudential" steps included stricter loan-to-value ratio calculations for property buys last year, and increased penalties for disposal of properties within five years.
Bank Negara has struck a more hawkish tone in recent meetings, giving investors strong hints that it is preparing to raise its benchmark rate from 3 percent.
At its last meeting in May, it said it may need to act to counter a "continued build-up of financial imbalances", specifically mentioning household debt as a main concern. Most economists expect a 0.25 percent hike when the central bank meets on Thursday, followed by another as early as September.
Veteran bank Governor Zeti Akhtar Aziz has her eye on rising inflation, which has turned real interest rates negative.
The government's recent moves to cut subsidies have increased prices of food, transport and electricity and lifted the annual inflation rate, which in May was 3.2 percent, up from 1.8 percent in June 2013.
Rising inflation since the last quarter of 2013 has also put the Philippines under pressure to raise interest rates after keeping policy rates at a record low since October 2012. Indonesia raised its interest rates five times last year.
Strong credit growth and rising consumer debt has been a common thread for Southeast Asian economies since major central banks slashed interest rates in response to the 2008 financial crisis and triggered a wave of easy money to emerging markets.
Malaysia, Singapore and Thailand all have debt-to-GDP ratios above 70 percent. Malaysia's ratio stands at 86.8 percent, up from 60.4 percent in 2008, and the second highest in Asia after South Korea's 91.1 percent.
More than half of the burgeoning household debt comes from housing loans, while personal and credit card loans account for 21 percent. It has helped drive a real-estate boom in parts of the country, with national house prices up 11.9 percent last year and Kuala Lumpur prices surging 30 percent in three years.
In contrast, the average monthly Malaysian household income rose about 7 percent annually from 2009-2012.
In an otherwise mostly glowing annual report on Malaysia's economy last week, the World Bank highlighted the risk to growth from the combination of high consumer debt and rising rates.
"Rate hikes are likely to have a relatively larger impact on household budgets than in the past," it said.
Economists say low wage earners will likely be hardest hit by high rates, but the overall effect on the economy should be limited as the bulk of credit is held by wealthier Malaysians.
"The weakest borrowers would feel the pinch with a 25-basis-points increase. Those in the middle income group can always adjust their spending," said Peck Boon Soon, RHB Bank's head of research.
Cheong, a 50-year-old father of three living in the capital Kuala Lumpur, says he was unable to pay off his 10,000 ringgit ($3,125) credit card debt after 4 years because of compounding interest rate payments. Even after his friend destroyed his credit card and lent him money, he is still finding it hard to make ends meet because of mortgage payments and rising expenses.
"It's tough when you have a family. I finally paid off my car loan but that sum is now used to finance my children's extra classes," he said.
$1 = 3.2 Malaysian ringgit Additional reporting by Stuart Grudgings and Al-Zaquan Amer Hamzah; Editing by Stuart Grudgings and Jacqueline Wong