##### Table of Contents

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FORM 10-QSB

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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



For the quarterly period ended June 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



KH FUNDING COMPANY

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



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Maryland                                                       |  | 52-1886133                          
|(state or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification Number)



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

(address of principal executive office)



(301) 592-8100

(telephone of principal executive office)



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 June 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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1



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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 Eight



2



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##### Table of Contents

KH FUNDING COMPANY

BALANCE SHEETS



|                                                                                                                                         |  |               |            |   |                  |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ---------- | - | ---------------- | - | ---------- | -
|                                                                                                                                         |  | June 30, 2004 |            |   | December 31,2003 |  
|                                                                                                                                         |  | (unaudited)   |            |   |                  |  
|Assets                                                                                                                                   |  |               |            |   |                  |   |            |  
|Notes ReceivableHeld for Yield, Net                                                                                                     |  | $             | 16,734,015 |   |                  | $ | 15,590,526 |  
|Accrued Interest Receivable                                                                                                              |  |               | 577,031    |   |                  |   | 515,495    |  
|Cash                                                                                                                                     |  |               | 552,819    |   |                  |   | 1,684,962  |  
|Prepaid Expenses                                                                                                                         |  |               | 428,169    |   |                  |   | 359,121    |  
|Other Receivables                                                                                                                        |  |               | 170,788    |   |                  |   | 1,126,791  |  
|Investments:                                                                                                                             |  |               |            |   |                  |   |            |  
|Marketable Securities                                                                                                                    |  |               | 2,602,758  |   |                  |   | 2,560,104  |  
|Other                                                                                                                                    |  |               | 158,872    |   |                  |   | 191,872    |  
|Property and EquipmentNet                                                                                                               |  |               | 38,265     |   |                  |   | 39,122     |  
|Real Estate Owned:                                                                                                                       |  |               |            |   |                  |   |            |  
|Rental Property                                                                                                                          |  |               | 856,687    |   |                  |   | 863,772    |  
|Held for Resale                                                                                                                          |  |               | 55,266     |   |                  |   | 150,482    |  
|Other Assets                                                                                                                             |  |               | 9,661      |   |                  |   | 8,661      |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Total Assets                                                                                                                             |  | $             | 22,184,331 |   |                  | $ | 23,090,908 |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|                                                                                                                                         |  |              
|Liabilities and Stockholders Equity                                                                                                     |  |               |            |   |                  |   |            |  
|                                                                                                                                         |  |              
|Liabilities                                                                                                                              |  |               |            |   |                  |   |            |  
|Notes and Accrued Interest Payable                                                                                                       |  | $             | 20,610,675 |   |                  | $ | 19,980,673 |  
|Participation Loans                                                                                                                      |  |               | 106,441    |   |                  |   | 105,636    |  
|Borrowings                                                                                                                               |  |               |           |   |                  |   | 1,300,200  |  
|Accounts Payable and Accrued Payroll Liabilities                                                                                         |  |               | 5,226      |   |                  |   | 2,562      |  
|Escrows and Deposits                                                                                                                     |  |               | 6,231      |   |                  |   | 19,924     |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Total Liabilities                                                                                                                        |  |               | 20,728,573 |   |                  |   | 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                                                                                                                          |  |               | 1,937,760  |   |                  |   | 2,102,765  |  
|Accumulated Deficit                                                                                                                      |  |               | (332,806   | ) |                  |   | (287,900   | )
|Less Subscription and Note Receivable                                                                                                    |  |               | (185,450   | ) |                  |   | (185,450   | )
|Cumulative other Comprehensive Income                                                                                                    |  |               | 11,198     |   |                  |   | 27,647     |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Total Stockholders Equity                                                                                                               |  |               | 1,455,758  |   |                  |   | 1,681,913  |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Total Liabilities and Stockholders Equity                                                                                               |  | $             | 22,184,331 |   |                  | $ | 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 Ended June 30, |         | For the Six Months EndedJune 30,
|                                                  |  | 2004                                |         |                                  | 2003 |   | 2004    |  |   | 2003     
|                                                  |  | (unaudited)                         |         | (unaudited)                     
|Interest Income                                   |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Interest and Fees on Loans                        |  | $                                   | 457,738 |                                  |      | $ | 480,654 |  | $ | 916,066   |   |  | $ | 947,103
|Interest on Bank Accounts                         |  |                                     | 1,142   |                                  |      |   | 1,608   |  |   | 1,712     |   |  |   | 3,349  
|Interest on InvestmentsMarketable Securities     |  |                                     | 30,693  |                                  |      |   | 20,113  |  |   | 60,975    |   |  |   | 31,339 
|Other Interest                                    |  |                                     | 23,553  |                                  |      |   | 3,245   |  |   | 29,638    |   |  |   | 6,491  
|                                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Total Interest Income                             |  |                                     | 513,126 |                                  |      |   | 505,620 |  |   | 1,008,391 |   |  |   | 988,282
|                                                  |  |                                     |         |                                 
|Interest Expense                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Interest and Fees on Borrowing                    |  |                                     | 292,509 |                                  |      |   | 288,529 |  |   | 581,918   |   |  |   | 577,261
|Interest on Participations                        |  |                                     | 3,632   |                                  |      |   | 33,329  |  |   | 7,284     |   |  |   | 54,112 
|                                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Total Interest Expense                            |  |                                     | 296,141 |                                  |      |   | 321,858 |  |   | 589,202   |   |  |   | 631,373
|                                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Net Interest Income                               |  |                                     | 216,985 |                                  |      |   | 183,762 |  |   | 419,189   |   |  |   | 356,909
|                                                  |  |                                     |         |                                 
|Provision for Loan Losses                         |  |                                     | 24,000  |                                  |      |   | 45,000  |  |   | 44,000    |   |  |   | 72,000 
|                                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Net Interest Income after Provision for Loan Loss |  |                                     | 192,985 |                                  |      |   | 138,762 |  |   | 375,189   |   |  |   | 284,909
|                                                  |  |                                     |         |                                 
|Non-interest Income                               |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Rental Income                                     |  |                                     | 16,870  |                                  |      |   | 18,290  |  |   | 36,924    |   |  |   | 38,428 
|Other                                             |  |                                     | 2,250   |                                  |      |   | 1,124   |  |   | 5,193     |   |  |   | 6,197  
|                                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Total Non-Interest Income                         |  |                                     | 19,120  |                                  |      |   | 19,414  |  |   | 42,117    |   |  |   | 44,625 
|                                                  |  |                                     |         |                                 
|Non-interest Expense                              |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Payroll                                           |  |                                     | 69,028  |                                  |      |   | 62,696  |  |   | 136,855   |   |  |   | 122,432
|Legal and Accounting                              |  |                                     | 37,266  |                                  |      |   | 17,318  |  |   | 67,363    |   |  |   | 29,294 
|Administration                                    |  |                                     | 51,019  |                                  |      |   | 22,501  |  |   | 89,324    |   |  |   | 39,209 
|Loss on Investment                                |  |                                     |        |                                  |      |   |        |  |   | 33,000    |   |  |   |       
|Real Estate                                       |  |                                     | 12,143  |                                  |      |   | 9,234   |  |   | 20,428    |   |  |   | 18,676 
|Insurance                                         |  |                                     | 17,359  |                                  |      |   | 12,240  |  |   | 37,293    |   |  |   | 24,320 
|Depreciation                                      |  |                                     | 11,757  |                                  |      |   | 12,636  |  |   | 26,341    |   |  |   | 25,351 
|Rent                                              |  |                                     | 10,659  |                                  |      |   | 10,158  |  |   | 21,318    |   |  |   | 20,317 
|Bank Charges                                      |  |                                     | 7,012   |                                  |      |   | 6,126   |  |   | 12,355    |   |  |   | 11,457 
|Other                                             |  |                                     | 9,922   |                                  |      |   | 1,856   |  |   | 17,935    |   |  |   | 2,953  
|                                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Total Non-Interest Expense                        |  |                                     | 226,165 |                                  |      |   | 154,765 |  |   | 462,212   |   |  |   | 294,009
|                                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        
|Net Income (Loss)                                 |  | $                                   | (14,060 | )                                |      | $ | 3,411   |  | $ | (44,906   | ) |  | $ | 35,525 
|                                                  |  |                                     |         |                                  |      |   |         |  |   |           |   |  |   |        



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



(unaudited)



|                                                                 |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |  |                          |          |   |  |   |         |   |  |   |           |  
|---------------------------------------------------------------- |  | ------------ | - |  | -------------- | ------ | - | ------------------ | - | --------- | ------------------------------- |  | - | -------------------- | - |  | ------------------------ | -------- | - |  | - | ------- | - |  | - | --------- | -
|                                                                 |  | 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                                                |  |             |   |  |                |       |   |                    |   | (185,780  | )                               |  |   |                     |   |  |                          |         |   |  |   |        |   |  |   | (185,780  | )
|                                                                 |  |              |   |  |                |        |  
|Comprehensive Income:                                            |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Net Income (Loss) for the period ended June 30, 2004             |  |              |   |  |                |        |   |                    |   |           |                                 |  |   | (44,906              | ) |  |                          |         |   |  |   |        |   |  |   | (44,906   | )
|Change in Market Value                                           |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                     |   |  |                          |         |   |  |   | (16,449 | ) |  |   | (16,449   | )
|                                                                 |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Total Comprehensive Income (Loss), Six Months Ended June 30,2004 |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |  |                          |          |   |  |   |         |   |  |   | (61,355   | )
|                                                                 |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Balance at June 30,2004                                          |  | 2,505,556    |   |  | $              | 25,056 |   |                    | $ | 1,937,760 |                                 |  | $ | (332,806             | ) |  | $                        | (185,450 | ) |  | $ | 11,198  |   |  | $ | 1,455,758 |  
|                                                                 |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                      |   |  |                          |          |   |  |   |         |   |  |   |           |  



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 SixMonthsEndedJune 30, |             |   | For the SixMonthsEndedJune 30, |  
|                                                                                        |  | 2004                           |             |   | 2003                           |  
|                                                                                        |  | (unaudited)                    |            
|Increase (Decrease) in Cash                                                             |  |                                |             |   |                                |   |            |  
|                                                                                        |  |                               
|Cash Flows from Operating Activities                                                    |  |                                |             |   |                                |   |            |  
|Interest Received from Borrowers                                                        |  | $                              | 854,530     |   |                                | $ | 771,182    |  
|Other Receipts                                                                          |  |                                | 157,532     |   |                                |   | 80,779     |  
|Interest Paid on Notes                                                                  |  |                                | (249,599    | ) |                                |   | (369,080   | )
|Paid-for Goods and Services                                                             |  |                                | (502,255    | ) |                                |   | (303,499   | )
|                                                                                        |  |                                |             |   |                                |   |            |  
|Net Cash Provided by Operating Activities                                               |  |                                | 260,208     |   |                                |   | 179,382    |  
|                                                                                        |  |                                |             |   |                                |   |            |  
|Cash Flows from Investing Activities                                                    |  |                                |             |   |                                |   |            |  
|Sale of Real Estate Held for Resale                                                     |  |                                | 90,795      |   |                                |   |           |  
|Principal Repayments from Borrowers                                                     |  |                                | 4,351,074   |   |                                |   | 2,949,722  |  
|Loans Made to Borrowers                                                                 |  |                                | (5,515,204  | ) |                                |   | (3,289,311 | )
|Proceeds from Sale of Fixed Assets                                                      |  |                                | (9,795      | ) |                                |   | (2,043     | )
|Collections of Other Receivables                                                        |  |                                | 1,000,000   |   |                                |   |           |  
|Payments for Other Receivables                                                          |  |                                | (43,997     | ) |                                |   | (393,517   | )
|Real Estate Improvements                                                                |  |                                | (1,398      | ) |                                |   | (10,194    | )
|Other Assets                                                                            |  |                                | (1,000      | ) |                                |   |           |  
|Purchase of Marketable Securities and Other Investments                                 |  |                                | (75,338     | ) |                                |   | (826,875   | )
|                                                                                        |  |                                |             |   |                                |   |            |  
|Net Cash Used in Investing Activities                                                   |  |                                | (204,863    | ) |                                |   | (1,572,218 | )
|                                                                                        |  |                               
|Cash Flows from Financing Activities                                                    |  |                                |             |   |                                |   |            |  
|Proceeds from issuance of Common Stock                                                  |  |                                | 26,061      |   |                                |   | 900        |  
|Redemption of Common Stock                                                              |  |                                | (5,081      | ) |                                |   | (13,751    | )
|Proceeds from Investors Notes                                                          |  |                                | 17,204,971  |   |                                |   | 10,856,794 |  
|Increase (Decrease) in Escrow                                                           |  |                                | (13,693     | ) |                                |   | 28,422     |  
|Principal Payments on Investor Notes                                                    |  |                                | (16,914,571 | ) |                                |   | (9,675,921 | )
|Increase (Decrease) in Participation Loans                                              |  |                                | 805         |   |                                |   | 641,906    |  
|Other Notes Payable, Net of Payments                                                    |  |                                | (1,300,200  | ) |                                |   | (334,071   | )
|Payment of Dividends                                                                    |  |                                | (185,780    | ) |                                |   | (149,249   | )
|                                                                                        |  |                                |             |   |                                |   |            |  
|Net Cash (Used in) Provided by Financing Activities                                     |  |                                | (1,187,488  | ) |                                |   | 1,355,030  |  
|                                                                                        |  |                                |             |   |                                |   |            |  
|Net Decrease in Cash                                                                    |  |                                | (1,132,143  | ) |                                |   | (37,806    | )
|Cash Balance, Beginning Of Interim Period                                               |  |                                | 1,684,962   |   |                                |   | 1,574,426  |  
|                                                                                        |  |                                |             |   |                                |   |            |  
|Cash Balance, End Of Interim Period                                                     |  | $                              | 552,819     |   |                                | $ | 1,536,620  |  
|                                                                                        |  |                                |             |   |                                |   |            |  
|Reconciliation of Net (Loss) Income to Net Cash from Operating Activities               |  |                                |             |   |                                |   |            |  
|Net (Loss) Income                                                                       |  | $                              | (44,906     | ) |                                | $ | 35,525     |  
|Adjustments to Reconcile Net (Loss) Income to Net Cash provided by Operating Activities |  |                                |             |   |                                |   |            |  
|Depreciation                                                                            |  |                                | 26,341      |   |                                |   | 25,351     |  
|Loss on Write-down of Investment                                                        |  |                                | 33,000      |   |                                |   |           |  
|Gain on Sale of Real Estate                                                             |  |                                | (2,785      | ) |                                |   |           |  
|Increase in Prepaid Expenses                                                            |  |                                | (69,048     | ) |                                |   | (32,937    | )
|Provision for Loan Losses                                                               |  |                                | 44,000      |   |                                |   | 72,000     |  
|Decrease in Interest Receivable (included in Notes Receivable)                          |  |                                | (45,302     | ) |                                |   | (159,404   | )
|Recovery of prior write-off                                                             |  |                                |            |   |                                |   | 4,815      |  
|Increase in Interest Payable (included in Notes Payable)                                |  |                                | 339,603     |   |                                |   | 262,293    |  
|(Decrease) Increase in Accounts Payable and Accrued Payroll Liabilities                 |  |                                | 2,664       |   |                                |   | (1,904     | )
|Change in Accrued Late Charges                                                          |  |                                | 6,941       |   |                                |   | (6,461     | )
|Amortization of points/fees                                                             |  |                                | (30,300     | ) |                                |   | (19,896    | )
|                                                                                        |  |                                |             |   |                                |   |            |  
|Net Cash Provided by Operating Activities                                               |  | $                              | 260,208     |   |                                | $ | 179,382    |  
|                                                                                        |  |                                |             |   |                                |   |            |  



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:



|                                         |  |                                 |         |   |             |   |         |  
|---------------------------------------- |  | ------------------------------- | ------- | - | ----------- | - | ------- | -
|                                         |  | Six Month Period Ended June 30, |        
|                                         |  | 2004                            |         |   | 2003        |  
|                                         |  | (unaudited)                     |         |   | (unaudited) |  
|Beginning balance                        |  | $                               | 211,000 |   |             | $ | 175,899 |  
|Additions charged to expenses            |  |                                 | 44,000  |   |             |   | 72,000  |  
|Write-off of loans                       |  |                                 | (61,372 | ) |             |   | (11,477 | )
|Recovery of loans previously charged off |  |                                 |        |   |             |   | 4,816   |  
|                                         |  |                                 |         |   |             |   |         |  
|                                         |  | $                               | 193,628 |   |             | $ | 241,238 |  



The following
information is presented as of:



|                                                                                             |  |             |         |          |   |        
|-------------------------------------------------------------------------------------------- |  | ----------- | ------- | -------- | - | -------
|                                                                                             |  | 06/30/04    |         | 12/31/03
|                                                                                             |  | (unaudited) |         |         
|Total recorded investment in impaired loans at the end of the period                         |  | $           | 572,112 |          | $ | 441,474
|Amount of that recorded investment for which there is a related allowance for credit losses  |  | $           | 200,544 |          | $ | 163,631
|Amount of related allowance for credit losses associated with such investment                |  | $           | 164,655 |          | $ | 120,307
|Amount of that recorded investment for which there is no related allowance for credit losses |  | $           | 371,568 |          | $ | 277,843



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



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KH FUNDING COMPANY



NOTES TO INTERIM UNAUDITED FINANCIAL INFORMATION



|                                                                                                                  |  |             |         |             |   |          |  |   |        
|----------------------------------------------------------------------------------------------------------------- |  | ----------- | ------- | ----------- | - | -------- |  | - | -------
|                                                                                                                  |  | 06/30/04    |         | 06/30/03    |   | 12/31/03
|                                                                                                                  |  | (unaudited) |         | (unaudited) |   |         
|The average recorded investment in impaired loans during the period.                                              |  | $           | 506,793 |             | $ | 193,395  |  | $ | 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
periods indicated:



|                                 |  |                           |           |        |   |                |  |   |       
|-------------------------------- |  | ------------------------- | --------- | ------ | - | -------------- |  | - | ------
|                                 |  | June 30, 2004 (unaudited)
|                                 |  | Cost                      |           | Market |   | UnrealizedGain
|Corporate Bonds (Net of Premium) |  | $                         | 2,437,400 |        | $ | 2,448,598      |  | $ | 11,198
|Money Market Fund                |  |                           | 114,715   |        |   | 114,715        |  |   |      
|Accrued Interest-Corporate Bonds |  |                           | 39,445    |        |   | 39,445         |  |   |      
|                                 |  |                           |           |        |   |                |  |   |       
|                                 |  | $                         | 2,591,560 |        | $ | 2,602,758      |  | $ | 11,198



NOTE DRELATED PARTY
TRANSACTIONS



Included in notes receivable at December 31,
2003 and June 30, 2004 are six notes totaling $865,798 and seven notes totaling $1,581,613, 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 $4,911,300 as of June 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



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KH FUNDING COMPANY





NOTES TO INTERIM UNAUDITED FINANCIAL
INFORMATION



eligible for such treatment and are in the process of
submitting a formal request to the Internal Revenue Service.



NOTE F-LOAN
CONCENTRATION



One borrower owes a total of $2,320,146 on
six loans outstanding as of June 30, 2004. Four of these loans for a total of $1,959,474 are buy, fix-up, 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 $360,672 are a first and second trust on the borrowers primary residence. The
primary residence also serves as additional collateral for the buy, fix-up and sell loans and the borrower and her husband have also personally guaranteed the repayment of these loans.



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##### Table of Contents

|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS 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, cash flows and contract awards. 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.



Overview



KH Funding Company conducts both mortgage banking and investment banking operations from its headquarters in Silver Spring, Maryland. Its primary business
activities consist of originating, acquiring and servicing mortgage loans, and issuing interest-bearing debt securities to investors. We emphasize the direct origination of small commercial real estate mortgage loans and investment property
residential mortgage loans. We purchase first and second trust residential loans nationwide from other lenders and banks.



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 any trading market to develop for the Notes. The offering is not underwritten and the Notes will be sold on a best efforts basis, with no broker dealers involved in the sale of the Notes at the outset, however it is
anticipated that a few broker-dealers will be involved in the sale of the notes in the near future. However, at present, the Notes will only be offered by Mr. Robert L. Harris, our President and Chief Executive Officer, who will not be compensated
for such services. The offering will terminate one year after the effective date of the prospectus.



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



Assets. Total assets decreased $.91 million, from $23.09 million at December 31, 2003 to $22.18 million at June 30, 2004. The size of our loan
portfolio increased by $1.14 million during the period, ending at $16.73 million. Cash decreased about $1.13 million from January to June



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##### Table of Contents

and Other Receivables decreased about $1,000,000 mostly due to the receipt of a subscription receivable for stock purchased.



Liabilities. Total liabilities decreased $0.68 million, from $21.41
million at December 31, 2003 to $20.73 million at June 30, 2004. The decrease was mostly a paydown of short-term borrowing on our margin account.



Equity. Total stockholders equity decreased from $1.68 million at December 31, 2003 to $1.46 million at June 30, 2004. The decrease was due
primarily to the payment of dividends in excess of profits during the period.



Non-accrual Loans. As of June 30, 2004, there were 20 loans not earning interest in non-accrual status with a carrying value of $572,112. About two-thirds of these loans, or $371,565 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 $200,547, are second trust loans for which we have a reserve set aside of
$164,655.



Delinquent Loans.We sometimes make
hard collateral loans, loans based largely on collateral, where the loan amount is normally 70% or less of the value of the collateral. As of June 30, 2004 we had twenty-three loans of $2,134,543 on our books that were more than 90 days
late but are still accruing interest. Eleven of the loans with a balance of $1,781,449 are hard collateral first trust loans on which we do 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 twenty-three loans we feel justified in continuing to accrue interest because we believe 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 June 30, 2004 and
2003



The average yield earned on loans receivable was
11.37% for the three months ended June 30, 2004, and 10.62% for the three months ended June 30, 2003. The increase was due to an increase in a newer category of loan (buy, fix-up and sell loans, i.e., short-term acquisition and renovation loans) on
which we receive significantly higher earnings and fees. The average rate paid on investor accounts declined to 5.54% in the three months ended June 30, 2004, from 6.19% in the three months ended June 30, 2003, due primarily to rollover by investors
of maturing higher interest rate notes. Overall, the net margin on interest increased to 5.83% for the three months ended June 30, 2004, from 4.43% for the three months ended June 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 June 30, 2004 was $14,060, compared to profit of $3,411 for the three months ended June 30, 2003. The major contributor to the loss was amortization for costs related to our debt offering.



Interest Income. Total interest income was $513,126 for the
three months ended June 30, 2004, compared to $505,620 for the same period in 2003. The interest income includes point and fee income and interest earned on bank investments and marketable securities.



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##### Table of Contents

Interest Expense. Interest expense was $296,141 for the three months ended June 30, 2004, and
$321,858 for the same period in 2003. The decrease resulted from a reduction in loan participations, which are treated as financings, and also from a lowering of the rate we were paying on investor notes. The interest expense includes fees paid for
loan purchases.



Provision for Loan Losses. We added
$24,000 to our provision for loan losses during the three months ended June 30, 2004, compared to $45,000 for the three months ended June 30, 2003. This increased the reserve to an amount deemed by management to be sufficient to meet all anticipated
specific 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 (Loss). We had non-interest income of $19,120 during the three months ended June 30, 2004, and $19,414 for the same period in 2003. The majority of the income in this category is rental
income from real estate owned, and to a lesser degree gains and losses on private-equity investments.



Non-Interest (Operating) Expense. We experienced an increase in non-interest expense to $226,165 for the three months ended June 30, 2004, from
$154,765 for the three months ended June 30, 2003. The majority of the increase was from an increase in costs related to our debt offering which was filed with the SEC in November 2003.



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 Six
Months Ended June 30, 2004 and 2003



The average yield
earned on loans receivable was 10.64% for the six months ended June 30, 2004 and 10.52% for the six months ended June 30, 2003. The increase was due to an increase in a newer category of loan (buy, fix-up and sell loans, i.e., short-term acquisition
and renovation loans) on which we receive significantly higher earnings and fees. The average rate paid on investor accounts declined to 5.56% in the six months ended June 30, 2004 from 6.22% in the six months ended June 30, 2003, due primarily to
rollover by investors of maturing higher interest rate notes. Overall, the net margin on interest increased to 5.08% for the six months ended June 30, 2004, from 4.30% for the six months ended June 30, 2003. The net margin is at note rates and
excludes fee income and expense.



Net Income (Loss). Net
loss for the six months ended June 30, 2004 was $44,906, compared to profit of $35,525 for the six months ended June 30, 2003. The major contributor to the loss was a write-off of a $33,000 private-equity investment, and amortization for costs
related to our public debt offering that we have paid and are expecting to benefit from beginning in the third quarter of this year.



Interest Income. Total interest income was $1,008,391 for the six months ended June 30, 2004, compared to $988,282 for the same period in 2003. The
interest income includes point and fee income and interest earned on bank investments and marketable securities.



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Interest Expense. Interest expense was $589,202 for the six months ended June 30, 2004, and
$631,373 for the same period in 2003. The decrease resulted from a reduction in loan participations, which are treated as financings, and also to a lowering of the rate we were paying on investor notes. The interest expense includes fees paid for
loan purchases.



Provision for Loan Losses. We added
$44,000 to our provision for loan losses during the six months ended June 30, 2004, compared to $72,000 for the six months ended June 30, 2003. This increased the reserve to an amount deemed by management to be sufficient to meet all anticipated
specific 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 (Loss). We had non-interest income of $42,117 during the six months ended June 30, 2004, and $44,625 for the same period in 2003. The majority of the income in this category is rental income
from real estate owned, and to a lesser degree gains and losses on private-equity investments.



Non-Interest (Operating) Expense. We experienced a large increase in non-interest expense to $462,212 for the six months ended June 30, 2004, from $294,009 for the six months ended June 30, 2003. The majority
of the increase of $168,203 was from an increase in costs related to our IPO which was filed with the SEC in November 2003, for example, during the period we realized $53,627 in amortization of offering costs and $38,000 for additional legal and
accounting services largely incurred as a result of us being a public reporting company.



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 a lot of turnover in our cash positions.



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 |                | $ | 24,697,776 |  | 92.74  | %
|6 Mos Ended 6/30/04 |  | $          | 17,204,971 |                | $ | 16,914,571 |  | 98.31  | %



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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. Management
believes that the risk of not being able to fund redemption requests only exists if the requests for redemption exceed the amount of readily available cash, i.e., if our liquidity is insufficient to fund redemptions. Upon the sale of a note, the
funds for redemption are immediately available. Of course, part of our investment strategy is to invest funds that will be invested with us for a longer period into higher yielding, slightly less liquid investments, such as bonds; nevertheless, the
funds are still available, just not immediately. Only holders of one-day demand notes can ask for funds sooner than thirty days, and we make an effort to keep funds available for these requests. For example, at June 30, 2004 we had outstanding, $2.5
million of one-day demand notes and held $3.2 million in cash and marketable securities and we would have been able to fund redemption requests from available funds for all one-day demand notes. Only holders of thirty-day demand notes can ask for
funds sooner than 90 days, and if necessary, we can sell participation interests in our loans (notes receivables) to have the funds available to meet requests from these note holders. Only holders of fixed-term notes, prior to maturity, can ask for
funds in 90 days, and if necessary, we can sell loans (notes receivables) in bulk to fund requests from these note holders. 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 earn higher yields than the first trust loans and 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, 2003 of $11,238,569 of 30-day demand and 1-year, 3-year and 5-year fixed notes, under which the investor could request redemption.



We will strive to maintain liquid resources in excess of demand obligations. This is accomplished by always watching our demand obligations and tailoring
our purchase of loans and cash positions according to such obligations.



Plan to Raise Additional Capital. As a result of our debt offering for $100 million, which was filed with the SEC and declared effective on August 2, 2004, we have been in discussions with several broker-dealers that belong to the
NASD and SIPC. We expect the broker-dealers will be selling our notes in the near future, and we believe that we will experience a significant inflow of investor money for our use to invest in loans and marketable securities. This should
result in increased profit.



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##### Table of Contents

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.



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 to 6.56% at June 30, 2004. During this time period total stockholders equity in dollars has remained fairly
constant while total assets 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 seven times that amount. Therefore, in the opinion of
management, in 1998 the ratio of total stockholders equity to total assets was higher than necessary.



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. This is not 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
|------- | -----------------------



As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of our principal
executive officer and principal financial officer, of our disclosure controls and procedures as defined in Rules 13(a)-15(e) under the Securities Exchange Act of 1934 (the Exchange Act). Based on this evaluation, the principal executive
officer and principal financial officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.



15



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##### Table of Contents

There were no changes in our internal control over financial reporting during our most recently completed
fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



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. Changes in Securities and Small Business Issuer Purchases of Equity Securities.



Not applicable



Item 3. Defaults Upon Senior Securities



Not applicable



Item 4. Submission of Matters to a Vote of Security Holders



On May 27, 2003, KH Funding held its Annual Meeting of Stockholders. There were a total of 2,486,066 votes entitled to be cast at the meting. Of this total, 1,534,227, or approximately 61.74% of the total number of
votes eligible to be cast, were represented either in person or by proxy. At the meeting, the stockholders elected seven (7) directors to KH Fundings Board of Directors. Set forth below are (i) the names of the persons elected to serve on KH
Fundings Board of Directors until the next Annual Meeting of Stockholders or until their successors are duly elected and qualified and (ii) the results of the voting for the nominees.



1. The election of the director nominees was presented to the stockholders for vote as a
slate. Set forth below are the results of that vote.



|                  |  |          |  |         
|----------------- |  | -------- |  | --------
|FOR               |  | AGAINST  |  | ABSTAIN 
|1,534,227(100.0%) |  | 0 (0.0%) |  | 0 (0.0%)



2. The stockholders also ratified the
appointment of Grant Thornton LLP, as KH Fundings independent public auditors for the fiscal year ended December 31, 2004. Set forth below are the results of that vote.



|                  |  |          |  |         
|----------------- |  | -------- |  | --------
|FOR               |  | AGAINST  |  | ABSTAIN 
|1,534,227(100.0%) |  | 0 (0.0%) |  | 0 (0.0%)



Item 5. Other Information



Not applicable



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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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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 August 16, 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.)