##### Table of Contents

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FORM 10-QSB



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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
|- | -------------------------------------------------------------------------------------------



For the quarterly period ended September 30, 2004



| ̈ | TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934
|- | --------------------------------------------------------------------------------------



For the transition period from  to



Commission File Number 333-106501



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KH FUNDING COMPANY

(Exact name of small business issuer as specified in its charter)



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|                                                              |  |                                    
|------------------------------------------------------------- |  | -----------------------------------
|Maryland                                                      |  | 52-1886133                         
|(state or other jurisdiction ofincorporation or organization) |  | (IRS EmployerIdentification Number)



10801 Lockwood
Drive, Suite 370, Silver Spring, Maryland 20901

(address of principal executive office)



(301) 592-8100

(telephone of principal executive office)



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Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of
the Securities Exchange Act of 1934 during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.    Yes  x    No ̈



APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE PRECEDING FIVE
YEARS



Check whether the registrant filed all documents and reports
required to be filed by Section l2, 13 or 15(d) of the Exchange Act after the distribution of securities under a plan confirmed by a court.    Yes ̈No ̈



APPLICABLE ONLY TO CORPORATE ISSUERS



State the number of shares outstanding of each of the issuers class of Common Stock as
of the latest practicable date.



|                                        |  |                                     
|--------------------------------------- |  | ------------------------------------
|Class                                   |  | Outstanding as of September 30, 2004
|Common Stock, $0.01 par value per share |  | 2,505,556                           



Transitional Small Business Disclosure
Format (Check One):    Yes  x    No ̈



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##### Table of Contents

PART I  FINANCIAL INFORMATION



|                                             |  |           
|-------------------------------------------- |  | ----------
|ITEM 1. UNAUDITED FINANCIAL STATEMENTS      
|                                             | 
|BALANCE SHEET                                |  | Page Three
|                                             | 
|STATEMENTS OF OPERATIONS                     |  | Page Four 
|                                             | 
|STATEMENTS OF CHANGE IN STOCKHOLDERS EQUITY |  | Page Five 
|                                             | 
|STATEMENTS OF CASH FLOWS                     |  | Page Six  
|                                             | 
|NOTES TO INTERIM FINANCIAL INFORMATION       |  | Page Seven



2



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##### Table of Contents

KH FUNDING COMPANY

BALANCE SHEETS



|                                                                                                                                         |  |                   |            |   |                  |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | ---------- | - | ---------------- | - | ---------- | -
|                                                                                                                                         |  | September 30,2004 |            |   | December 31,2003 |  
|                                                                                                                                         |  | (unaudited)       |            |   |                  |  
|Assets                                                                                                                                   |  |                   |            |   |                  |   |            |  
|Notes ReceivableHeld for Yield, Net                                                                                                     |  | $                 | 18,606,846 |   |                  | $ | 15,590,526 |  
|Accrued Interest Receivable                                                                                                              |  |                   | 674,912    |   |                  |   | 515,495    |  
|Cash                                                                                                                                     |  |                   | 791,072    |   |                  |   | 1,684,962  |  
|Prepaid Expenses                                                                                                                         |  |                   | 523,293    |   |                  |   | 359,121    |  
|Other Receivables                                                                                                                        |  |                   | 144,322    |   |                  |   | 1,126,791  |  
|Investments:                                                                                                                             |  |                   |            |   |                  |   |            |  
|Marketable securities                                                                                                                    |  |                   | 2,666,299  |   |                  |   | 2,560,104  |  
|Other                                                                                                                                    |  |                   | 158,872    |   |                  |   | 191,872    |  
|Property and EquipmentNet                                                                                                               |  |                   | 37,385     |   |                  |   | 39,122     |  
|Real Estate Owned:                                                                                                                       |  |                   |            |   |                  |   |            |  
|Rental Property                                                                                                                          |  |                   | 642,835    |   |                  |   | 863,772    |  
|Held for Resale                                                                                                                          |  |                   |           |   |                  |   | 150,482    |  
|Other Assets                                                                                                                             |  |                   | 9,911      |   |                  |   | 8,661      |  
|                                                                                                                                         |  |                   |            |   |                  |   |            |  
|Total Assets                                                                                                                             |  | $                 | 24,255,747 |   |                  | $ | 23,090,908 |  
|                                                                                                                                         |  |                   |            |   |                  |   |            |  
|Liabilities and Stockholders Equity                                                                                                     |  |                   |            |   |                  |   |            |  
|                                                                                                                                         |  |                  
|Liabilities                                                                                                                              |  |                   |            |   |                  |   |            |  
|Participation Loans                                                                                                                      |  | $                 | 106,185    |   |                  | $ | 105,636    |  
|Notes and Accrued Interest Payable                                                                                                       |  |                   | 21,424,714 |   |                  |   | 19,980,673 |  
|Borrowings                                                                                                                               |  |                   | 1,300,200  |   |                  |   | 1,300,200  |  
|Accounts Payable and Accrued Payroll Liabilities                                                                                         |  |                   | 4,742      |   |                  |   | 2,562      |  
|Escrows                                                                                                                                  |  |                   | 29,805     |   |                  |   | 19,924     |  
|                                                                                                                                         |  |                   |            |   |                  |   |            |  
|Total Liabilities                                                                                                                        |  |                   | 22,865,646 |   |                  |   | 21,408,995 |  
|                                                                                                                                         |  |                  
|Stockholders Equity                                                                                                                     |  |                   |            |   |                  |   |            |  
|Common Stock (5,000,000 shares authorized; 2,505,556 shares and 2,485,066 shares, respectively, issued and outstanding; $0.01 par
value) |  |                   | 25,056     |   |                  |   | 24,851     |  
|Paid-in-Capital                                                                                                                          |  |                   | 1,844,101  |   |                  |   | 2,102,765  |  
|Accumulated Deficit                                                                                                                      |  |                   | (340,266   | ) |                  |   | (287,900   | )
|Less Subscription and Note Receivable                                                                                                    |  |                   | (185,450   | ) |                  |   | (185,450   | )
|Cumulative other comprehensive income                                                                                                    |  |                   | 46,660     |   |                  |   | 27,647     |  
|                                                                                                                                         |  |                   |            |   |                  |   |            |  
|Total Stockholders Equity                                                                                                               |  |                   | 1,390,101  |   |                  |   | 1,681,913  |  
|                                                                                                                                         |  |                   |            |   |                  |   |            |  
|Total Liabilities and Stockholders Equity                                                                                               |  | $                 | 24,255,747 |   |                  | $ | 23,090,908 |  
|                                                                                                                                         |  |                   |            |   |                  |   |            |  



The accompanying notes
are an integral part of these statements.



3



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##### Table of Contents

KH FUNDING COMPANY

STATEMENTS OF OPERATIONS



|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|------------------------------------------------- |  | --------------------------------------- | ------- | -------------------------------------- | ---- | - | ------- |  | - | --------- | - |  | - | ---------
|                                                  |  | For the Three Months EndedSeptember 30, |         | For the Nine Months EndedSeptember 30,
|                                                  |  | 2004                                    |         |                                        | 2003 |   | 2004    |  |   | 2003     
|                                                  |  | (unaudited)                             |         | (unaudited)                           
|Interest Income                                   |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Interest and Fees on Loans                        |  | $                                       | 500,674 |                                        |      | $ | 462,936 |  | $ | 1,416,740 |   |  | $ | 1,410,039
|Interest on Bank Accounts                         |  |                                         | 29,913  |                                        |      |   | 18,525  |  |   | 90,889    |   |  |   | 49,864   
|Interest on InvestmentsMarketable Securities     |  |                                         | 837     |                                        |      |   | 2,229   |  |   | 2,550     |   |  |   | 5,577    
|Other Interest                                    |  |                                         | 3,245   |                                        |      |   | 32,183  |  |   | 32,883    |   |  |   | 38,674   
|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Total Interest Income                             |  |                                         | 534,669 |                                        |      |   | 515,873 |  |   | 1,543,062 |   |  |   | 1,504,154
|                                                  |  |                                         |         |                                       
|Interest Expense                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Interest and Fees on Borrowing                    |  |                                         | 319,055 |                                        |      |   | 276,046 |  |   | 888,652   |   |  |   | 853,307  
|Interest on Participation                         |  |                                         | 3,632   |                                        |      |   | 19,453  |  |   | 10,916    |   |  |   | 73,565   
|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Total Interest Expense                            |  |                                         | 322,687 |                                        |      |   | 295,499 |  |   | 899,568   |   |  |   | 926,872  
|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Net Interest Income                               |  |                                         | 211,982 |                                        |      |   | 220,374 |  |   | 643,494   |   |  |   | 577,282  
|                                                  |  |                                         |         |                                       
|Provision for Loan Losses                         |  |                                         | 70,700  |                                        |      |   | 60,000  |  |   | 114,700   |   |  |   | 132,000  
|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Net Interest Income after Provision for Loan Loss |  |                                         | 141,282 |                                        |      |   | 160,374 |  |   | 528,794   |   |  |   | 445,282  
|                                                  |  |                                         |         |                                       
|Non-interest Income                               |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Rental Income                                     |  |                                         | 17,864  |                                        |      |   | 17,853  |  |   | 54,788    |   |  |   | 56,280   
|Gain on Sale of Investment                        |  |                                         | 55,615  |                                        |      |   |        |  |   | 55,615    |   |  |   |         
|Other                                             |  |                                         | 2,840   |                                        |      |   | 1,878   |  |   | 8,032     |   |  |   | 8,075    
|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Total Non-Interest Income                         |  |                                         | 76,319  |                                        |      |   | 19,731  |  |   | 118,435   |   |  |   | 64,355   
|                                                  |  |                                         |         |                                       
|Non-interest Expense                              |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Payroll                                           |  |                                         | 82,954  |                                        |      |   | 64,802  |  |   | 219,809   |   |  |   | 187,234  
|Legal and Accounting                              |  |                                         | 27,173  |                                        |      |   | 14,875  |  |   | 94,537    |   |  |   | 44,168   
|Administration                                    |  |                                         | 56,889  |                                        |      |   | 22,843  |  |   | 158,534   |   |  |   | 62,054   
|Loss on Investment                                |  |                                         |        |                                        |      |   |        |  |   | 33,000    |   |  |   |         
|Real Estate                                       |  |                                         | 8,656   |                                        |      |   | 14,077  |  |   | 29,085    |   |  |   | 32,754   
|Insurance                                         |  |                                         | 13,072  |                                        |      |   | 13,607  |  |   | 50,365    |   |  |   | 37,928   
|Depreciation                                      |  |                                         | 11,549  |                                        |      |   | 12,674  |  |   | 37,890    |   |  |   | 38,025   
|Rent                                              |  |                                         | 10,659  |                                        |      |   | 10,158  |  |   | 31,976    |   |  |   | 30,475   
|Bank Charges                                      |  |                                         | 6,917   |                                        |      |   | 5,618   |  |   | 19,272    |   |  |   | 17,075   
|Other                                             |  |                                         | 7,192   |                                        |      |   | 4,626   |  |   | 25,127    |   |  |   | 7,579    
|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Total Non-Interest Expense                        |  |                                         | 225,061 |                                        |      |   | 163,280 |  |   | 699,595   |   |  |   | 457,292  
|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          
|Net Income (Loss)                                 |  | $                                       | (7,460  | )                                      |      | $ | 16,825  |  | $ | (52,366   | ) |  | $ | 52,345   
|                                                  |  |                                         |         |                                        |      |   |         |  |   |           |   |  |   |          



The accompanying notes
are an integral part of these statements.



4



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##### Table of Contents

KH FUNDING COMPANY

STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY



|                                                           |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |                          |   |          |   |  |   |        |  |   |           |  
|---------------------------------------------------------- |  | ------------ | - |  | -------------- | ------ | - | ------------------ | - | --------- | ------------------------------- |  | - | -------------------- | - | ------------------------ | - | -------- | - |  | - | ------ |  | - | --------- | -
|                                                           |  | Common Stock |   |  | Paid-inCapital |        |   | AccumulatedDeficit |   |           | Subscriptionsand NoteReceivable |  |   | Change inMarketValue |   | TotalStockholdersEquity |  
|                                                           |  | Shares       |   |  | Amount         |        |   |                    |   |           |                                
|Balance at December 31, 2003                               |  | 2,485,066    |   |  |                | 24,851 |   |                    |   | 2,102,765 |                                 |  |   | (287,900             | ) |                          |   | (185,450 | ) |  |   | 27,647 |  |   | 1,681,913 |  
|                                                           |  |              |   |  |                |        |  
|Additional Stock Issued                                    |  | 22,788       |   |  |                | 228    |   |                    |   | 25,833    |                                 |  |   |                     |   |                          |   |         |   |  |   |       |  |   | 26,061    |  
|Stock Redeemed                                             |  | (2,298       | ) |  |                | (23    | ) |                    |   | (5,058    | )                               |  |   |                     |   |                          |   |         |   |  |   |       |  |   | (5,081    | )
|Dividend Declared                                          |  |             |   |  |                |       |   |                    |   | (279,439  | )                               |  |   |                     |   |                          |   |         |   |  |   |       |  |   | (279,439  | )
|Comprehensive Income:                                      |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |                          |   |          |   |  |   |        |  |   |           |  
|Net Income (Loss) for the Nine months Ended Sept. 30, 2004 |  |              |   |  |                |        |   |                    |   |           |                                 |  |   | (52,366              | ) |                          |   |         |   |  |   |       |  |   | (52,366   | )
|Change in Market Value                                     |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                     |   |                          |   |         |   |  |   | 19,013 |  |   | 19,013    |  
|                                                           |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |                          |   |          |   |  |   |        |  |   |           |  
|Total Comprehensive Loss, Nine months Ended Sept. 30, 2004 |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |                          |   |          |   |  |   |        |  | $ | (33,353   | )
|                                                           |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |                          |   |          |   |  |   |        |  |   |           |  
|Balance at Sept. 30, 2004 (unaudited)                      |  | 2,505,556    |   |  | $              | 25,056 |   |                    | $ | 1,844,101 |                                 |  | $ | (340,266             | ) |                          | $ | (185,450 | ) |  | $ | 46,660 |  | $ | 1,390,101 |  
|                                                           |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |                          |   |          |   |  |   |        |  |   |           |  



The accompanying notes
are an integral part of these statements.



5



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##### Table of Contents

KH FUNDING COMPANY

STATEMENTS OF CASH FLOWS



|                                                                                        |  |                                        |             |   |      |   |             |  
|--------------------------------------------------------------------------------------- |  | -------------------------------------- | ----------- | - | ---- | - | ----------- | -
|                                                                                        |  | For the Nine Months EndedSeptember 30, |            
|                                                                                        |  | 2004                                   |             |   | 2003 |  
|                                                                                        |  | (unaudited)                            |            
|Increase (Decrease) in Cash                                                             |  |                                        |             |   |      |   |             |  
|                                                                                        |  |                                       
|Cash Flows from Operating Activities                                                    |  |                                        |             |   |      |   |             |  
|Interest Received from Borrower                                                         |  | $                                      | 1,257,323   |   |      | $ | 1,213,140   |  
|Other Receipts                                                                          |  |                                        | 203,289     |   |      |   | 117,279     |  
|Interest Paid on Notes                                                                  |  |                                        | (390,824    | ) |      |   | (509,988    | )
|Paid-for Goods and Services                                                             |  |                                        | (825,520    | ) |      |   | (550,751    | )
|                                                                                        |  |                                        |             |   |      |   |             |  
|Net Cash Provided by Operating Activities                                               |  |                                        | 244,268     |   |      |   | 269,680     |  
|                                                                                        |  |                                       
|Cash Flows from Investing Activities                                                    |  |                                        |             |   |      |   |             |  
|Principal Repayments from Borrowers                                                     |  |                                        | 5,678,576   |   |      |   | 4,830,365   |  
|Loans Made to Borrowers                                                                 |  |                                        | (8,775,658  | ) |      |   | (4,593,624  | )
|Purchase (Sale) of Property and Equipment                                               |  |                                        | (14,237     | ) |      |   | (2,043      | )
|Payments for Other Receivables                                                          |  |                                        | 982,469     |   |      |   | 28,939      |  
|Payments on Other Real Estate Owned                                                     |  |                                        | (10,155     | ) |      |   | (16,250     | )
|Other Assets                                                                            |  |                                        | (1,250      | ) |      |   | 2,000       |  
|Proceeds from Sale of Other Real Estate Owned                                           |  |                                        | 416,896     |   |      |   |            |  
|Purchase of marketable securities and other investments                                 |  |                                        | (102,268    | ) |      |   | (637,312    | )
|                                                                                        |  |                                        |             |   |      |   |             |  
|Net Cash Used in Investing Activities                                                   |  |                                        | (1,825,627  | ) |      |   | (387,925    | )
|                                                                                        |  |                                       
|Cash Flows from Financing Activities                                                    |  |                                        |             |   |      |   |             |  
|Redemption of Common Stock                                                              |  |                                        | (5,081      | ) |      |   | (23,640     | )
|Proceeds from Sale of Common Stock                                                      |  |                                        | 26,061      |   |      |   | 5,040       |  
|Proceeds from Investors Notes                                                          |  |                                        | 35,201,956  |   |      |   | 16,880,241  |  
|Increase (Decrease) in Escrow                                                           |  |                                        | 10,081      |   |      |   | (2,902      | )
|Principal Payments on Investor Notes                                                    |  |                                        | (34,266,658 | ) |      |   | (15,309,422 | )
|Increase (Decrease) in Participation Loans                                              |  |                                        | 549         |   |      |   | (253,425    | )
|Increase (Decrease) in Borrowings                                                       |  |                                        |            |   |      |   | (333,877    | )
|Payment of Dividends                                                                    |  |                                        | (279,439    | ) |      |   | (232,116    | )
|                                                                                        |  |                                        |             |   |      |   |             |  
|Net Cash Provided by Financing Activities                                               |  |                                        | 687,469     |   |      |   | 729,899     |  
|                                                                                        |  |                                        |             |   |      |   |             |  
|Net Increase/(Decrease) in Cash                                                         |  |                                        | (893,890    | ) |      |   | 611,654     |  
|Cash Balance, beginning of interim period                                               |  |                                        | 1,684,962   |   |      |   | 1,574,426   |  
|                                                                                        |  |                                        |             |   |      |   |             |  
|Cash Balance, end of interim period                                                     |  | $                                      | 791,072     |   |      | $ | 2,186,080   |  
|                                                                                        |  |                                        |             |   |      |   |             |  
|Reconciliation of Net Income (Loss) to Net Cash from Operating Activities               |  |                                        |             |   |      |   |             |  
|Net Income (Loss)                                                                       |  | $                                      | (52,366     | ) |      | $ | 52,350      |  
|Adjustments to Reconcile Net Income (Loss) to Net Cash provided by Operating Activities |  |                                        |             |   |      |   |             |  
|Depreciation                                                                            |  |                                        | 37,890      |   |      |   | 38,025      |  
|Accretion of Interest on Note Payable                                                   |  |                                        | 9,051       |   |      |   | 3,011       |  
|Loss on Write Down of Investment                                                        |  |                                        | 33,000      |   |      |   |            |  
|Gain (Loss) on Sale of Assets                                                           |  |                                        | (55,615     | ) |      |   |            |  
|(Increase) Decrease in Prepaid Expenses                                                 |  |                                        | (165,995    | ) |      |   | (127,450    | )
|Loan Loss Reserve Expense                                                               |  |                                        | 114,700     |   |      |   | 132,000     |  
|Increase (Decrease) in Interest Receivable (included in Notes Receivable)               |  |                                        | (144,332    | ) |      |   | (196,899    | )
|Recovery of prior write-off                                                             |  |                                        | 4,800       |   |      |   | 4,815       |  
|Increase in Interest Payable (included in Notes Payable)                                |  |                                        | 499,693     |   |      |   | 414,201     |  
|(Decrease) Increase in Accounts Payable and Accrued Payroll Liabilities                 |  |                                        | 2,180       |   |      |   | (4,367      | )
|Change in Accrued Late Charges                                                          |  |                                        | 6,562       |   |      |   | (9,811      | )
|Amortization of points/fees                                                             |  |                                        | (45,300     | ) |      |   | (36,195     | )
|                                                                                        |  |                                        |             |   |      |   |             |  
|Net Cash Provided by Operating Activities                                               |  | $                                      | 244,268     |   |      | $ | 269,680     |  



The accompanying notes
are an integral part of these statements.



6



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##### Table of Contents

KH FUNDING COMPANY



NOTES TO
INTERIM UNAUDITED FINANCIAL INFORMATION



NOTE ABASIS OF
PRESENTATION



The accompanying unaudited financial
statements have been prepared in conformity with generally accepted accounting principles in the United States (GAAP) for interim financial information, as well as in accordance with the instructions to Form 10-QSB. In the opinion of
management the financial statements reflect all the adjustments consisting only of normal recurring accruals necessary for a fair presentation of the results for such periods. Accordingly, the information and footnotes required by GAAP for complete
financial statements are not included. Operating results for interim periods reflected do not necessarily indicate the results that may be expected for a full fiscal year. You should read these financial statements in conjunction with the financial
statements and the notes thereto included in the Companys annual report on Form 10-KSB at December 31, 2003.



NOTE B



Analysis of the allowance for loan loss is as follows:



|                                         |  |                                      |          |   |                  |   |         |  
|---------------------------------------- |  | ------------------------------------ | -------- | - | ---------------- | - | ------- | -
|                                         |  | Nine Month Period EndedSeptember 30, |         
|                                         |  | 2004 (unaudited)                     |          |   | 2003 (unaudited) |  
|                                         | 
|Beginning balance                        |  | $                                    | 211,000  |   |                  | $ | 175,899 |  
|Additions charged to expense             |  |                                      | 114,700  |   |                  |   | 132,000 |  
|Write-off of loans                       |  |                                      | (130,179 | ) |                  |   | (89,880 | )
|Recovery of loans previously charged off |  |                                      | 4,800    |   |                  |   | 4,815   |  
|                                         |  |                                      |          |   |                  |   |         |  
|Total                                    |  | $                                    | 200,321  |   |                  | $ | 228,833 |  



The following
information is presented as of:



|                                                                                             |  |                     |         |                  |   |        
|-------------------------------------------------------------------------------------------- |  | ------------------- | ------- | ---------------- | - | -------
|                                                                                             |  | 09/30/04(unaudited) |         | December 31,2004
|Total recorded investment in impaired loans at the end of the period                         |  | $                   | 646,494 |                  | $ | 441,474
|Amount of that recorded investment for which there is a related allowance for credit losses  |  | $                   | 205,502 |                  | $ | 163,631
|Amount of related allowance for credit losses associated with such investment                |  | $                   | 151,520 |                  | $ | 120,307
|Amount of that recorded investment for which there is no related allowance for credit losses |  | $                   | 440,992 |                  | $ | 277,843



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KH FUNDING COMPANY



NOTES TO INTERIM UNAUDITED FINANCIAL INFORMATION



The following average information is presented for the year and periods ended:



|                                                                                                                  |  |                     |         |                     |   |                  |  |   |        
|----------------------------------------------------------------------------------------------------------------- |  | ------------------- | ------- | ------------------- | - | ---------------- |  | - | -------
|                                                                                                                  |  | 09/30/04(unaudited) |         | 09/30/03(unaudited) |   | December 31,2003
|The average recorded investment in impaired loans during the period.                                              |  | $                   | 543,984 |                     | $ | 299,197          |  | $ | 308,436
|The related amount of interest income recognized within that period when the loans were impaired.                 |  | $                   |        |                     | $ |                 |  | $ |       
|The amount of income recognized using a cash basis during the time within that period that the loan was impaired. |  | $                   |        |                     | $ |                 |  | $ |       



NOTE CINVESTMENTS



Marketable securities consist of the following at the
period indicated:



|                                 |  |                               |           |        |   |                |  |   |       
|-------------------------------- |  | ----------------------------- | --------- | ------ | - | -------------- |  | - | ------
|                                 |  | September 30, 2004(unaudited)
|                                 |  | Cost                          |           | Market |   | UnrealizedGain
|Corporate Bonds (Net of Premium) |  | $                             | 2,428,997 |        | $ | 2,475,657      |  | $ | 46,660
|Money Market Fund                |  |                               | 141,647   |        |   | 141,647        |  |   |      
|Accrued Interest-Corporate Bonds |  |                               | 48,995    |        |   | 48,995         |  |   |      
|                                 |  |                               |           |        |   |                |  |   |       
|Total                            |  | $                             | 2,619,639 |        | $ | 2,666,299      |  | $ | 46,660



NOTE DRELATED PARTY
TRANSACTIONS



Included in notes receivable at December 31,
2003 and September 30, 2004 are six notes totaling $865,798 and seven notes totaling $1,824,608 respectively, from officers, stockholders and a company controlled by an officer. These notes all have annual maturities and are due in full on the
maturity date unless extended by the Company. The interest rates on these notes range between 5.99% and 12.5%.



Included in the notes payable balance at December 31, 2003, are 49 notes totaling $5,508,831 and 46 notes totaling $4,836,067 as of September 30, 2004
which are held by stockholders. These notes were all issued at the rate in effect for the applicable term selected as of the date the note was issued.



NOTE ESUB-S CORPORATE STATUS



During the preparation of the 2003 income tax returns for the Company, it was discovered that during 2003, and previously in 1998, stock in the Company
was transferred to shareholders who were ineligible to be S corporation shareholders.



The effect of such a transfer is to terminate the S election on the date of the first of these transfers. However, the Internal Revenue Service has a process by which they will allow the S election to continue based
on inadvertent terminations. We believe that the Company is eligible for such treatment and have submitted a formal request to the Internal Revenue Service.



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KH FUNDING COMPANY



NOTES TO INTERIM UNAUDITED FINANCIAL INFORMATION



NOTE F-LOAN CONCENTRATION



One borrower owes a total of $3,361,266 on eight loans outstanding as of September 30, 2004. Six of these loans for a total of $3,001,230 are buy,
renovate, sell loans on residential properties where we loan 100% of the acquisition and renovation cost. We are repaid from the proceeds of sale. This same borrower over the last twelve months borrowed from us on four other properties that have
been sold and we have been paid off. The other two loans for a total of $360,036 are a first and second trust on the borrowers primary residence. The primary residence also serves as additional collateral for the buy, renovate and sell loans and the
borrower and her relatives have also pledged additional collateral which we believe to constitute substantial tangible, saleable assets. As a result, we continue to classify these amounts as notes receivable and accrue related interest. Accrued
interest on such loans total $157,927 as of September 30, 2004. In addition, the borrowers have personally guaranteed the repayment of these loans.



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION



Managements Discussion and Analysis or Plan of Operation and other sections contain
forward-looking statements that are based on managements expectations, estimates, projections and assumptions. Words such as expects, anticipates, plans, believes, estimates and
variations of such words and similar expressions are intended to identify such forward-looking statements that include, but are not limited to, projections of revenues, earnings, segment performance and cash flows. Such forward-looking statements
are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future performance and involve certain risks and uncertainties that are difficult to predict. Therefore,
actual future results and trends may differ materially from what is indicated in forward-looking statements due to a variety of factors.



MANAGEMENTS DISCUSSION AND ANALYSIS



Overview



KH Funding Company is a mortgage banking company that invests in mortgages throughout the United States. It is a U.S. Securities and Exchange Commission
registered issuer of fixed income securities and an approved Trustee for retirement plans and IRA accounts. Through an arrangement with Bank of America the Company is able to offer its investors access to their funds through Bank of America checking
accounts.



The Company owns and services an active mortgage
portfolio consisting primarily of short-term commercial property and investment residential property mortgage loans. Over the years the Company has identified several niches in the mortgage investment area and has proven itself successful in
obtaining consistent performance and results.



Our net income
depends largely upon our net interest income, which is the difference between interest income from loans and investments, referred to as interest-earning assets, and interest expense on investor notes and other borrowed funds, referred to as
interest-bearing liabilities. Our net interest income may be affected by general economic conditions, policies established by regulatory authorities and competition.



Recent Developments



Public Offering. On August 2, 2004 our Registration Statement on Form SB-2 (333-117038) was declared effective by the U.S. Securities and Exchange
Commission. We registered $80,000,000 of Series 3 Senior Secured Investment Debt Securities and $20,000,000 of Series 4 Subordinated Unsecured Investment Debt Securities. We do not expect a trading market to develop for the Notes. At present, the
Notes are being offered by the Company by Mr. Robert L. Harris, its President and Chief Executive Officer, who will not be compensated for such services, and by Capital Financial Services, a broker-dealer member of the National Association of
Securities Dealers, that is being compensated for its services. The offering will terminate no later than one year after the effective date of the prospectus.



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##### Table of Contents

Comparison of Financial Condition at September 30, 2004 and December 31, 2003



Assets. Total assets increased $1,164,839, from $23,090,908 at
December 31, 2003 to $24,255,747 at September 30, 2004. The size of our loan portfolio was increased $3,016,320. From $15,590,526 at December 31, 2003 to $18,606,846 at September 30, 2004.



Liabilities. Total liabilities increased $1,456,651, from $21,408,995
at December 31, 2003 to $22,865,646 at September 30, 2004. The increase was primarily in notes payable to investors, which increased from $19,980,673 at December 31, 2003 to $21,424,714 at September 30, 2004.



Equity. Total stockholders equity decreased $291,812, from
$1,681,913 at December 31, 2003 to $1,390,101 at September 30, 2004. The decrease was due primarily to the payment of dividends in excess of profits during the period.



Non-accrual Loans. As of September 30, 2004, there were sixteen loans not earning interest in non-accrual status with
a carrying value of $646,494. About two-thirds of these loans, or $440,992 are first trust loans that are well collateralized. In the event we have to foreclose on any of these loans, we do not expect to lose significant sums. The other one-third of
these loans, or $205,502, are second trust loans for which we have a reserve set aside of $151,520.



Delinquent Loans.We sometimes make what are known as hard collateral loans, or loans based largely on collateral value, where the
value of the collateral is below 70% of the loan amount. As of September 30, 2004 we had twenty-seven loans on our books that were more than 90 days late but are still accruing interest. The total amount due on these loans was $2,199,806. Fifteen of
the loans, owing $1,928,724 are hard collateral first trust loans on which we would not expect to lose any significant amount, and the other twelve loans are paying currently or we anticipate that they will be doing so shortly. For these loans we
feel justified in continuing to accrue interest because we expect we will be paid in full. These loans are monitored more closely for trouble than any other loans in our portfolio.



Comparison of Operating Results for Three Months Ended September 30, 2004 and 2003



The average yield earned on loans receivable was 10.53% for the three months
ended September 30, 2004, and 11.04% for the three months ended September 30, 2003. The decrease was due mainly to borrowers paying off some of the higher interest rate loans and an increase in the investment in lower-yielding loans. The average
rate paid on investor accounts increased to 5.75% in the three months ended September 30, 2004 from 5.65% in the three months ended September 30, 2003. Overall, the net margin on interest decreased to 4.78% for the three months ended September 30,
2004, from 5.39% for the three months ended September 30, 2003. The net margin is at note rates and excludes fee income and expense.



Net Income/Loss. Net loss for the three months ended September 30, 2004 was $7,460, compared to a profit of $16,825 for the three months ended
September 30, 2003. The loss was due largely to expenses in 2004 but not incurred in 2003 related to the amortization of capitalized offering costs.



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Interest Income. Total interest income was $534,669 for the three months ended September 30, 2004,
compared to $515,873 for the same period in 2003. The additional income resulted from growth in the average amount of interest-earning assets between the two periods. The interest income includes point and fee income and interest earned on bank
investments and marketable securities.



Interest
Expense. Interest expense was $322,867 for the three months ended September 30, 2004, and $295,499 for the same period in 2003. The reduced expense primarily resulted from a decrease in loan participations, which are treated as financings, and
the accompanying interest expense for the participants share. The interest expense includes fees paid for loan purchases.



Provision for Loan Losses. We added $70,700 to our provision for loan losses during the three months ended September 30, 2004, compared to $60,000
for the three months ended September 30, 2003. This increased the reserve to an amount deemed by management to be sufficient to meet all anticipated loan losses plus a general amount to meet unforeseen loan losses. The adequacy of the allowance is
periodically reviewed and adjusted by management based upon past experience, the value of the underlying collateral for specific loans, known or inherent risks in the loan portfolio and current economic conditions.



Non-Interest Income. We had non-interest income of $76,319 during the
three months ended September 30, 2004 and $19,731 for the same period in 2003. The increase resulted mostly from a Gain on Sale of Real Estate owned.



Non-Interest (Operating) Expense. We experienced an increase in non-interest expense to $225,061 for the three months ended September 30, 2004 from
$163,280 for the three months ended September 30, 2003. The majority of the increase was for payroll and outside professional services mainly related to offering costs, which are included in Administration Expense.



Income Taxes. KH Funding Company is a Subchapter S corporation under
the Internal Revenue code and accordingly no items appear for income taxes.



Comparison of Operating Results for Nine Months Ended September 30, 2004 and 2003



The average yield earned on loans receivable was 10.60% for the nine months ended September 30, 2004, and 10.69% for the nine months ended September 30,
2003. The decrease was due mainly to borrowers paying off some of the higher interest rate loans. The average rate paid on investor accounts declined to 5.62% in the nine months ended September 30, 2004 from 6.04% in the nine months ended September
30, 2003, due primarily to rollover by investors of maturing higher interest rate notes. Overall, the net margin on interest increased to 4.98% for the nine months ended September 30, 2004, from 4.66% for the nine months ended September 30, 2003.
The net margin is at note rates and excludes fee income and expense.



Net Income/Loss. Net loss for the nine months ended September 30, 2004 was $52,366, compared to a profit of $52,345 for the nine months ended September 30, 2003. The loss was due largely to approximately $88,000 of expenses in 2004
but not incurred in 2003 related to the amortization of capitalized offering costs.



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Interest Income. Total interest income was $1,543,062 for the nine months ended September 30,
2004, compared to $1,504,154 for the same period in 2003. The additional income resulted from growth in the average amount of interest-earning assets between the two periods. The interest income includes point and fee income and interest earned on
bank investments and marketable securities.



Interest
Expense. Interest expense was $899,568 for the nine months ended September 30, 2004, and $926,872 for the same period in 2003. The reduced expense primarily resulted from a decrease in loan participations, which are treated as financings, and
the accompanying interest expense for the participants share. The interest expense includes fees paid for loan purchases.



Provision for Loan Losses. We added $114,700 to our provision for loan losses during the nine months ended September 30, 2004, compared to $132,000
for the nine months ended September 30, 2003. This increased the reserve to an amount deemed by management to be sufficient to meet all anticipated loan losses plus a general amount to meet unforeseen loan losses. The adequacy of the allowance is
periodically reviewed and adjusted by management based upon past experience, the value of the underlying collateral for specific loans, known or inherent risks in the loan portfolio and current economic conditions.



Non-Interest Income. We had non-interest income of $118,435 during the
nine months ended September 30, 2004 and $64,355 for the same period in 2003. The increase resulted mostly from a Gain on Sale of Real Estate owned.



Non-Interest (Operating) Expense. We experienced an increase in non-interest expense to $699,595 for the nine months ended September 30, 2004 from
$457,292 for the nine months ended September 30, 2003. The majority of the increase was for payroll and outside services mainly related to offering costs, which are included in Administration Expense.



Income Taxes. KH Funding Company is a Subchapter S corporation under
the Internal Revenue code and accordingly no items appear for income taxes.



Liquidity and Capital Resources



KH Funding
Companys primary sources of capital are the proceeds from the sale of securities to investors, principal and interest payments on loans, sales of participation interests in loans and rental income. While maturities and scheduled amortization
of loans and investments are predictable sources of funds, the sale and redemption of investor notes and mortgage loan prepayments are greatly influenced by interest rate trends, economic conditions and competition. Our One Day Demand Notes cause
substantial turnover in our cash positions.



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The table below illustrates the Sales of Notes versus Redemptions for the years indicated:



|                       |  |            |            |                |   |            |  |        |  
|---------------------- |  | ---------- | ---------- | -------------- | - | ---------- |  | ------ | -
|Year                   |  | Notes Sold |            | Notes Redeemed |   | Percentage | 
|1999                   |  | $          | 7,376,780  |                | $ | 5,455,205  |  | 73.95  | %
|2000                   |  | $          | 10,367,351 |                | $ | 10,661,308 |  | 102.84 | %
|2001                   |  | $          | 14,418,456 |                | $ | 11,280,177 |  | 78.23  | %
|2002                   |  | $          | 22,926,619 |                | $ | 18,681,654 |  | 81.47  | %
|2003                   |  | $          | 26,630,166 |                | $ | 24,697,770 |  | 92.74  | %
|Through Sept. 30, 2004 |  | $          | 35,201,956 |                | $ | 34,266,658 |  | 97.34  | %



During the past few
years, the combination of generally low interest rates on deposit products at commercial banks, the poor performance of the stock market and increasing referrals from customers have positioned KH Funding to experience solid growth in the number of
new investors attracted to its investment products. Based on its monitoring of historic trends and its current pricing strategy for investor accounts, management believes KH Funding Company will retain a large portion of its existing investors and
will experience a significant increase of funds from new investors in the future.



Redemption of Notes Payable.



One-Day Demand Notes. Holders of One-Day Demand Notes may call, visit or write the Company to exercise the demand feature of the Note for all or part of the funds they have invested in such Note. The Company will fund the redemption request
within one business day of the date of demand. At the option of the Noteholder, the Company will also provide One-Day Demand Noteholders with a checking account at Bank of America, which they can use to access the funds they have invested.



The holders of One-Day Demand Notes are the only class of
Noteholder that may request their funds with only one day of advance notice to the Company. The risk of the Company not being able to fund such redemption requests could exist if the amount of demand obligations (redemption requests) exceed the
amount of readily available cash. Therefore, management strives to maintain liquid resources in excess of demand obligations by carefully monitoring our demand obligations and tailoring our liquid resources according to such obligations.



For example, at December 31, 2003 we had outstanding, $1,700,639 of
one-day demand notes and $4,245,066 in cash and marketable securities, and, therefore, our cash far exceeded any possible demand obligations that could exist. At September 30, 2004 we had outstanding, $3,595,418 of one-day demand notes and
$3,457,371 in cash and marketable securities, and, therefore, we had slightly below the amount of cash necessary to fund all demand obligations that could exist. This situation was unusual because we had higher than normal redemption activity over a
short period of time, but in such event we have a second-tier of cash availability, which is to sell notes receivable (mortgage loans in our portfolio) to other lenders, as necessary to balance our cash needs.



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Thirty-Day Demand Notes. Holders of Thirty-Day Demand Notes may call, visit or write the Company to
exercise the demand feature of the Note for all or part of the funds they have invested in such Note. The Company will fund the redemption request within thirty days of the date of demand, and will confirm receipt of the redemption request and the
date for the request to be funded, in writing, and a copy of such confirmation will be mailed to the Noteholder. As mentioned above, management strives to maintain liquid resources in excess of demand obligations by carefully monitoring our demand
obligations and tailoring our liquid resources according to such obligations.



For example, at December 31, 2003 we held $10,425,739 in first trust residential and commercial property loans that could be sold in part, to a participant bank, or in whole, to other lenders, at or above par value.
Further, we held $4,683,148 in business line-of-credit loans and second trust loans, which can also be sold, although they generally take longer to sell and are normally sold at a discount. The significance of the Company holding these notes that
could be sold is that their value is more than necessary to meet the Notes payable maturities for year ended December 31, 2004 of $11,736,710 of Thirty-Day Demand and 1-Year, 3-Year and 5-Year Fixed Notes, under which the investor could request
redemption. Note C to the Financial Statement discusses the notes payable maturities in more detail.



One, Three and Five-Year Notes. The holders of these Notes will normally hold the Notes to maturity, but they do have the right to demand a partial or
full redemption upon ninety days advance notice to the Company, subject to a penalty. In order to allow for such early redemption requests, we keep fairly accessible funds available, and, if necessary, we can sell participation interests in our
loans (notes receivables) or sell our loans in bulk, to fund requests from Note holders.



Plan to Raise Additional Capital. We intend to continue to expand our operations through future offerings of debt, and possibly through the sale of loan participation interests and sales of capital stock. We
believe that our checking account access feature for our one-day demand notes will be popular with investors, and we expect that we will be able to attract more investors to our longer-term fixed rate notes because we now offer trust services for
IRA accounts through our Trust Services Department.



Known Trends, Events or
Uncertainties



Impact of Inflation and Interest
Rates. The financial statements of KH Funding and notes thereto, presented elsewhere herein, have been prepared in accordance with accounting principles generally accepted in the United States of America, which require the measurement of
financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time and due to inflation. The impact of inflation is generally to increase the value of underlying
collateral for the loans made by KH Funding to its borrowers. Unlike typical industrial companies, nearly all the assets and liabilities of KH Funding are monetary in nature. As a result, interest rates have a greater impact on our performance than
the effects of inflation generally.



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##### Table of Contents

Stockholders equity. Total stockholders equity has decreased as a percentage of total
assets over the last five years, from 11.8% at December 31, 1998 to 7.3% at December 31, 2003 and 5.74% at September 30, 2004. During this time period total stockholders equity in dollars has remained fairly constant while total assets in
dollars have increased, causing the equity-to-assets ratio to decrease. Although the ratio has decreased and is a smaller percentage compared to what it has been in the past, management believes the current ratio is still adequate for
noteholders protection. Managements belief is based in part upon the fact that historically we have had loan losses of less than 1% per year, and the ratio is more than four times that amount. Therefore, in the opinion of management, in
1998 the ratio of total stockholders equity to total assets was higher than necessary. Management intends to maintain a ratio of 4-7% and, although it is not a certainty, management anticipates such a ratio is very attainable given that the
most recent offering is underway, the net proceeds have been invested and profits from those investments are expected to be realized shortly.



Recent Accounting Pronouncements



We have evaluated the impact on financial results, financial condition and cash flows of recently adopted accounting standards that are not yet effective
for possible impact on the Company. This includes FIN 46R, Consolidation of Variable Interest Entities. None of these are expected to have an impact on the Company.



The preceding paragraphs discussing the Companys financial condition contain forward-looking statements. The factors affecting the
ability of the Company to meet its funding requirements and manage its cash resources include, among other things, the amount and timing of product sales, inventory turnover, the magnitude of fixed costs, sales growth and the ability to obtain
working capital, all of which involve risks and uncertainties that are difficult to predict.



ITEM 3. CONTROLS AND PROCEDURES



EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES



The
Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in our periodic reports filed with the Securities and Exchange Commission (SEC) is recorded, processed, summarized
and reported within the time periods specified in the SECs rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to
allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable
assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.



As of the end of the period covered by this report, the Company carried out
an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based
on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective.



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CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING



There have been no significant changes in our internal controls over financials reporting or in other factors that have
materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting in the three months since the Company last evaluated the system of internal controls in conjunction with the preparation of financial
statements for the period covered by this report.



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##### Table of Contents

PART II  OTHER INFORMATION



ITEM 1. LEGAL PROCEEDINGS



The Company is not engaged in any material legal proceedings at the present time. From time to time, the Company is a party to legal proceedings within
the normal course of business wherein it enforces its security interest in loans made by it and other matters of a like kind.



ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS



None.



ITEM 3. DEFAULTS UPON SENIOR SECURITIES



None.



ITEM 4. SUBMISSION OF MATTERS TO A
VOTE OF SECURITY HOLDERS



None.



ITEM 5. OTHER INFORMATION



None.



ITEM 6. EXHIBITS AND REPORT ON FORM 8-K



| | (a) | Exhibits
| | --- | --------



|               |  |                                                                                                                                                  
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------
|               | 
|Exhibit 31.1 - |  | Certification by the Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                           
|               | 
|Exhibit 31.2 - |  | Certification by the Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                           
|               | 
|Exhibit 32.1 - |  | Certification by the Chief Executive Officer Pursuant to 18 U.S.C. Section 1350 Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
|               | 
|Exhibit 32.2 - |  | Certification by the Chief Financial Officer Pursuant to 18 U.S.C. Section 1350 Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002



| | (b) | Reports on Form 8-K
| | --- | -------------------



None.



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##### Table of Contents

SIGNATURE



In accordance with the requirements of the Securities Exchange Act of 1934, the Registrant caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.



KH
FUNDING COMPANY

(Registrant)



|                        |  |                                                 
|----------------------- |  | ------------------------------------------------
|Dated November 12, 2004 |  | /s/ Louise B. Sehman                            
|                        |  | Louise B. Sehman                                
|                        |  | Chief Financial Officer, Secretary and Treasurer



(Ms. Sehman is the Principal Financial
and Accounting Officer and has been duly authorized to sign on behalf of the Registrant.)



19