**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**_______________________________**





**FORM
      10-Q**











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





For
      the
      Quarterly Period Ended June 30, 2008





**OR**





o
            **TRANSITION
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES****EXCHANGE
                ACT OF 1934**





For
      the
      transition period from ________ to ________





Commission
      file number 333-106501





**KH
      FUNDING COMPANY**


(Exact
      name of registrant as specified in its charter)





Maryland
            52-1886133(State
                or Other Jurisdiction of
            (I.R.S.
                EmployerIncorporation
                or Organization)
            Identification
                No.)10801
                Lockwood Drive, Suite 370, Silver Spring, Maryland
            20901(Address
                of Principal Executive Offices)
            (Zip
                Code)





(301)
      592-8100


Registrant’s
      Telephone Number, Including Area Code





N/A


Former
      name, former address and former fiscal year, if changed since last
      report.





Indicate
      by check mark whether the registrant (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter periods 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 o





Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, a non-accelerated filer or a smaller reporting company.
      See
      the definitions of “large accelerated filer”, “accelerated filer” and “smaller
      reporting company” in Rule 12b-2 of the Exchange Act. (Check one):





Large
                accelerated filer o
            Accelerated
                filer oNon-accelerated
                filer o
            Smaller
                reporting company x


(Do
      not
      check if a smaller reporting company)





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Act).Yes o No x





**APPLICABLE
      ONLY TO CORPORATE ISSUERS**





Indicate
      the number of shares outstanding of each of the issuer’s classes of common
      stock, as of the latest practicable date: 2,574,981 shares, par value $.01
      per
      share, of common stock outstanding as of June 30, 2008.





**INDEX**





**Page**





Part
                I. Financial Information
            3Item
                1. Financial Statements
            3Balance
                Sheets -June
                30, 2008 (unaudited) and December 31, 2007
            3Statements
                of Operations (unaudited) -For
                the three and six months ended June 30, 2008 and 2007
            4Statements
                of Changes in Stockholders’ Equity (unaudited) -For
                the six months ended June 30, 2008 and 2007
            5Statements
                of Cash Flows (unaudited) -For
                the six months ended June 30, 2008 and 2007
            6Notes
                to Interim Financial Statements (unaudited)
            7Item
                2. Management’s Discussion and Analysis of Financial Condition and Results
                of Operations
            12Item
                4T. Controls and Procedures
            18Part
                II. Other Information
            18Item
                1. Legal Proceedings
            18Item
                6. Exhibits
            19Signatures
            19Exhibit
                Index
            20




2


**PART
      I - FINANCIAL INFORMATION**





**Item
      1. Financial Statements.**





**KH
      FUNDING COMPANY**


**BALANCE
      SHEETS**





**June
                30,**
              **2008**
            
            **December
                31,**
              **2007****(unaudited)**
            
            ******Assets**Cash
            
            $
            209,224
            
            $
            95,622Investments
                available for sale:Stock
                in closely-held corporation
            
            
            25,437
            
            
            25,437Loans
                receivable, less allowance for loan losses of $592,124(June
                30, 2008) and $495,480 (December 31, 2007)
            
            
            42,574,751
            
            
            47,885,188Accrued
                interest receivable
            
            
            1,595,302
            
            
            2,668,649Other
                receivables
            
            
            610,729
            
            
            106,944Prepaid
                expenses
            
            
            190,981
            
            
            208,549Property
                and equipment - Net
            
            
            121,286
            
            
            141,993Real
                estate owned:Rental
                property
            
            
            1,368,741
            
            
            675,914Held
                for sale
            
            
            1,889,402
            
            
            1,568,655Other
                assets
            
            
            15,988
            
            
            15,988**Total
                Assets**
            
            $
            48,601,841
            
            $
            53,392,939**Liabilities
                and Stockholders’ Equity****Liabilities**Notes
                and accrued interest payable
            
            $
            42,058,968
            
            $
            51,219,963Other
                loans payable
            
            
            1,195,425
            
            
            702,094Accounts
                payable and accrued expenses
            
            
            32,922
            
            
            32,827Escrows
                and security deposits
            
            
            119,097
            
            
            101,383Long-term
                liabilities
            
            
            41,099
            
            
            35,842Participation
                loans
            
            
            4,700,375
            
            
            261,764**Total
                Liabilities**
            
            
            48,147,886
            
            
            52,353,873**Stockholders’
                Equity**Common
                stock (5,000,000 shares authorized; 2,574,981 shares (June 30, 2008)
                and
                2,724,981 shares (December 31, 2007) issued and outstanding, $0.01
                par
                value)
            
            
            25,750
            
            
            27,250Paid-in
                capital
            
            
            1,440,203
            
            
            1,730,911Accumulated
                deficit
            
            
            (826,548
            )
            
            (533,645
            )Subscription
                note receivable
            
            
            (185,450
            )
            
            (185,450
            )**Total
                Stockholders’ Equity**
            
            
            453,955
            
            
            1,039,066**Total
                Liabilities and Stockholders’ Equity**
            
            $
            48,601,841
            
            $
            53,392,939





*The
      accompanying notes are an integral part of these statements.*


3




**KH
      FUNDING COMPANY**


**STATEMENTS
      OF OPERATIONS (UNAUDITED)**




**For
                the Three**
              **Months**
              **Ended
                June 30,**
            
            **For
                the Six**
              **Months**
              **Ended
                June 30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****Interest
                Income**Interest
                and fees on loans
            
            $
            1,052,310
            
            $
            1,532,229
            
            $
            2,266,447
            
            $
            3,048,058Interest
                on bank accounts
            
            
            33
            
            
            377
            
            
            78
            
            
            5,711Interest
                on investments —marketable securities
            
            
            -
            
            
            7,346
            
            
            -
            
            
            18,728Total
                interest income
            
            
            1,052,343
            
            
            1,539,952
            
            
            2,266,525
            
            
            3,072,497**Interest
                Expense**Interest
                and fees on notes
            
            
            754,139
            
            
            928,615
            
            
            1,623,916
            
            
            1,935,049Interest
                on other loans
            
            
            14,740
            
            
            141,326
            
            
            106,375
            
            
            219,209Interest
                on participation loans
            
            
            103,593
            
            
            -
            
            
            111,661
            
            
            -Total
                interest expense
            
            
            872,472
            
            
            1,069,941
            
            
            1,841,952
            
            
            2,154,258Net
                interest income
            
            
            179,871
            
            
            470,011
            
            
            424,573
            
            
            918,239**Provision
                for Loan Losses**
            
            
            75,000
            
            
            75,000
            
            
            154,098
            
            
            120,000**Net
                Interest Income after Provision for Loan Losses**
            
            
            104,871
            
            
            395,011
            
            
            270,475
            
            
            798,239**Non-interest
                Income**Rental
                income
            
            
            26,613
            
            
            15,416
            
            
            49,043
            
            
            29,521Loss
                on sale of real estate owned
            
            
            (4,732
            )
            
            (11,872
            )
            
            (4,732
            )
            
            (11,872
            )Other
            
            
            1,336
            
            
            2,736
            
            
            8,575
            
            
            5,704Total
                non-interest income
            
            
            23,217
            
            
            6,280
            
            
            52,886
            
            
            23,353**Non-interest
                Expense**Salaries
                and wages
            
            
            81,559
            
            
            121,665
            
            
            168,436
            
            
            234,852Professional
                fees
            
            
            54,573
            
            
            33,903
            
            
            104,532
            
            
            64,380Offering
                costs
            
            
            39,423
            
            
            36,000
            
            
            72,203
            
            
            83,402Administration
            
            
            32,971
            
            
            3,813
            
            
            49,674
            
            
            42,520Real
                estate maintenance
            
            
            34,206
            
            
            53,723
            
            
            55,378
            
            
            78,298Insurance
            
            
            21,526
            
            
            16,063
            
            
            38,631
            
            
            28,630Depreciation
            
            
            14,709
            
            
            14,782
            
            
            30,339
            
            
            28,827Rent
            
            
            28,097
            
            
            28,968
            
            
            57,916
            
            
            57,973Bank
                charges
            
            
            13,038
            
            
            11,983
            
            
            26,793
            
            
            20,623Stock
                based compensation — employees
            
            
            4,268
            
            
            4,000
            
            
            7,792
            
            
            11,500Other
            
            
            1,698
            
            
            3,876
            
            
            4,570
            
            
            13,708Total
                non-interest expense
            
            
            326,068
            
            
            328,776
            
            
            616,264
            
            
            664,713**Net
                (Loss) Income**
            
            $
            (197,980
            )
            $
            72,515
            
            $
            (292,903
            )
            $
            156,879Basic
                earnings per share
            
            $
            (0.08
            )
            $
            0.03
            
            
            (0.11
            )
            $
            0.06Diluted
                earnings per share
            
            $
            (0.08
            )
            $
            0.03
            
            
            (0.11
            )
            $
            0.06Cash
                dividends paid per common share
            
            $
            -
            
            $
            0.02
            
            
            -
            
            $
            0.04




*The
      accompanying notes are an integral part of these
      statements.*


4




**KH
      FUNDING COMPANY**


**STATEMENTS
      OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)**


**FOR
      THE SIX MONTHS ENDED JUNE 30, 2008 and 2007**





**Common
                Stock**
            
            **Paid-In**
            
            **Accumulated**
            
            **Subscription
                Note**
            
            **Accumulated
                Other Comprehensive**
            
            **Total
                Stockholders’****Shares**
            
            **Amount**
            
            **Capital**
            
            **Deficit**
            
            **Receivable**
            
            **(Loss)
                Income**
            
            **Equity****Balances
                at January 1, 2007**
            
            
            2,726,951
            
            $
            27,269
            
            $
            1,879,783
            
            $
            (269,120
            )
            $
            (185,450
            )
            $
            (34,168
            )
            $
            1,418,314**Additional
                stock issued**
            
            
            330
            
            
            4
            
            
            856
            
            
            -
            
            
            -
            
            
            -
            
            
            860**Dividends
                (paid $0.04 per share)**
            
            
            
            
            
            
            
            
            (109,083
            )
            
            
            
            
            
            
            
            
            
            
            (109,083
            )**Stock
                Based Compensation Expense**
            
            
            
            
            
            
            
            
            11,500
            
            
            -
            
            
            -
            
            
            -
            
            
            11,500**Comprehensive
                income**Net
                income for period ended June 30, 2007
            
            
            -
            
            
            -
            
            
            -
            
            
            156,879
            
            
            -
            
            
            -
            
            
            156,879Change
                in fair value of investments
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            7,692
            
            
            7,692**Total
                Comprehensive Income for the Period**
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            164,571**Balances
                at June 30, 2007**
            
            
            2,727,281
            
            $
            27,273
            
            $
            1,783,056
            
            $
            (112,241
            )
            $
            (185,450
            )
            $
            (26,476
            )
            $
            1,486,162**Balances
                at January 1, 2008**
            
            
            2,724,981
            
            $
            27,250
            
            $
            1,730,911
            
            $
            (533,645
            )
            $
            (185,450
            )
            $
            -
            
            $
            1,039,066**Stock
                Redemption**
            
            
            (150,000
            )
            
            (1,500
            )
            
            (298,500
            )
            
            -
            
            
            -
            
            
            -
            
            
            (300,000
            )**Stock
                Based Compensation Expense**
            
            
            
            
            
            
            
            
            7,792
            
            
            
            
            
            
            
            
            
            
            
            7,792Net
                loss for period ended June 30, 2008
            
            
            -
            
            
            -
            
            
            -
            
            
            (292,903
            )
            
            -
            
            
            -
            
            
            (292,903
            )**Balances
                at June 30, 2008**
            
            
            2,574,981
            
            $
            25,750
            
            $
            1,440,203
            
            $
            (826,548
            )
            $
            (185,450
            )
            $
            -
            
            $
            453,955





*The
      accompanying notes are an integral part of these statements.*


5




**KH
      FUNDING COMPANY**


**STATEMENTS
      OF CASH FLOWS (UNAUDITED)**





**For
                the six months ended June 30,****2008**
            
            **2007****Cash
                from Operating Activities**Net
                (loss) income
            
            $
            (292,903
            )
            $
            156,879**Adjustments
                to Reconcile Net Income to Net Cash from Operating
                Activities:**Depreciation
            
            
            30,339
            
            
            28,827Amortization
                of loan fees
            
            
            (14,608
            )
            
            (57,000
            )Provision
                for loan losses
            
            
            154,098
            
            
            120,000Loss
                on sale of real estate owned
            
            
            4,732
            
            
            11,872Stock
                based compensation expense
            
            
            7,792
            
            
            11,500**Changes
                in Operating Assets and Liabilities**Accrued
                late charges
            
            
            (10,257
            )
            
            (6,479
            )Prepaid
                expenses
            
            
            22,676
            
            
            36,211Interest
                receivable
            
            
            1,073,347
            
            
            (340,475
            )Interest
                payable (included in notes payable)
            
            
            1,016,912
            
            
            1,170,799Accounts
                payable and accrued expenses
            
            
            95
            
            
            1,205Prepaid
                offering costs
            
            
            (5,108
            )
            
            50,014Deferred
                loan origination costs
            
            
            6,900
            
            
            4,320Unamortized
                brokerage fees
            
            
            32,750
            
            
            (2,881
            )Long
                term lease liability
            
            
            5,257
            
            
            -Prepaid
                loan expenses
            
            
            51,297
            
            
            -**Net
                Cash Provided by Operating Activities**
            
            
            2,083,319
            
            
            1,184,792**Cash
                Flows from Investing Activities**Principal
                repayments from borrowers
            
            
            9,291,650
            
            
            7,127,337Loans
                made to borrowers
            
            
            (5,199,922
            )
            
            (6,669,592
            )Purchase
                of marketable securities and other investments
            
            
            -
            
            
            (728
            )Receivable
                for participation loan
            
            
            (451,000
            )
            
            -Net
                other receivable
            
            
            (52,785
            )
            
            381,193Purchase
                of fixed assets
            
            
            -
            
            
            (41,889
            )Proceeds
                from sale of real estate owned
            
            
            16,151
            
            
            478,472Payments
                on other real estate owned
            
            
            (12,810
            )
            
            (4,600
            )**Net
                Cash Provided by Investing Activities**
            
            
            3,591,284
            
            
            1,270,193**Cash
                Flows from Financing Activities**Proceeds
                from investor notes
            
            
            980,692
            
            
            1,568,912Principal
                payments on investor notes
            
            
            (11,191,349
            )
            
            (15,697,823
            )Increase
                in participation loans
            
            
            4,438,611
            
            
            -Increase
                in borrowings
            
            
            493,331
            
            
            23,322,450Payments
                on borrowings
            
            
            -
            
            
            (14,736,683
            )Payment
                of dividends
            
            
            -
            
            
            (109,083
            )Proceeds
                from sale of common stock
            
            
            -
            
            
            860Redemption
                of common stock
            
            
            (300,000
            )
            
            -Decrease
                in escrow and security deposits
            
            
            17,714
            
            
            5,448**Net
                Cash Used in Financing Activities**
            
            
            (5,561,001
            )
            
            (5,645,919
            )**Net
                Increase (Decrease) in Cash**
            
            
            113,602
            
            
            (3,190,934
            )**Cash
                Balance,**beginning of period
            
            
            95,622
            
            
            3,823,013**Cash
                Balance,**end
                of period
            
            $
            209,224
            
            $
            623,079**Supplemental
                Cash Flow Information:**Interest
                paid
            
            $
            825,040
            
            $
            983,459Transfer
                of loans to real estate owned
            
            $
            1,031,280
            
            $
            306,922




*The
      accompanying notes are an integral part of these statements.*


6




KH
      Funding Company


Notes
      to
      Interim Financial Statements


For
      the
      Six Months Ended June, 2008 and 2007


(Unaudited)





**NOTE
      A—BASIS OF PRESENTATION**





The
      financial statements of KH Funding Company (the “Company”) conform to accounting
      principles generally accepted in the United States of America (“GAAP”) and to
      prevailing practices within the Company’s industry. The accompanying interim
      financial statements are unaudited; however, in the opinion of management all
      adjustments necessary to present fairly the financial position at June 30,
      2008,
      the results of operations for the three- and six-month periods ended June 30,
      2008 and 2007, changes in stockholders’ equity for the six-month periods ended
      June 30, 2008 and 2007, and cash flows for the six-month periods ended June
      30,
      2008 and 2007, have been included. All such adjustments are of a normal
      recurring nature. The amounts as of December 31, 2007 were derived from audited
      financial statements. The results of operations for the three- and six-month
      periods ended June 30, 2008 are not necessarily indicative of the results to
      be
      expected for any other interim period or for the full year. This Quarterly
      Report on Form 10-Q should be read in conjunction with the Company’s Annual
      Report on Form 10-KSB for the year ended December 31, 2007.





The
      financial statements contemplate continuation of the Company as a going concern.
      As discussed in Note B to the audited financial statements presented in the
      Company’s Annual Report on Form 10-KSB for the year ended December 31, 2007, the
      Company has experienced significant delays in obtaining an effective
      registration statement covering the offer and sale of its investor notes. We
      continue to pursue our registration efforts and filed an amendment to our most
      recent registration statement on August 4, 2008 with the Securities and Exchange
      Commission (the “SEC”) and several state securities regulators. This amendment
      has not yet been declared effective. This delay, if it continues, presents
      a
      significant risk that the Company may have difficulty meeting its future
      liquidity needs. The Company requires cash to make and acquire loans, redeem
      outstanding investor notes, and pay other operational expenses. Although the
      Company anticipates that it will continue to receive unscheduled and scheduled
      loan payments on a going-forward basis, there can be no guaranty that income
      generated from loan payoffs and scheduled payments in the future will exceed
      the
      amounts needed to fund redemption requests and pay other operational expenses.
      Additionally, stockholders’ equity at June 30, 2008 has decreased to 0.93% of
      total assets, which the Company believes to be inadequate to fully protect
      it
      against potential losses. Accordingly, because both future income from loans
      and
      cash needed for operations, including investor note redemptions, are uncertain
      and because the Company cannot predict when, if at all, its registration
      statement covering the offer and sale of investor notes will be declared
      effective, there is substantial doubt about the Company’s ability to continue as
      a going concern.





**NOTE
      B—SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING
      PRONOUNCEMENTS**





**Significant
      Accounting Policies and Estimates**





Note
      A to
      the audited financial statements contained in the Company’s Annual Report on
      Form 10-KSB for the year ended December 31, 2007 describes the significant
      accounting policies used in the preparation of the Company’s financial
      statements.





**Nature
      of Operation** **s**





The
      Company conducts 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.
      The
      Company purchases residential first and second mortgage loans from other lenders
      and banks primarily in the Baltimore, MD and Washington DC metropolitan areas.
      The Company also directly originates small commercial real estate mortgage
      loans
      and investment property residential mortgage loans.





**Use
      of Estimates in Preparing Financial Statements**





In
      preparing financial statements in conformity with GAAP, management is required
      to make estimates and assumptions that affect the reported amounts of assets
      and
      liabilities and the disclosure of contingent assets and liabilities at the
      date
      of the financial statements and revenue and expenses during the reporting
      period. Actual results could differ materially from those
      estimates.





**Earnings
      Per Share**





Basic
      earnings per share is derived by dividing net income available to common
      stockholders by the weighted-average number of common shares outstanding and
      does not include the effect of any potentially dilutive common stock
      equivalents. Diluted earnings per share is derived by dividing net income by
      the
      weighted-average number of shares outstanding, adjusted for the dilutive effect
      of outstanding stock options. As of June 30, 2008 and June 30, 2007, the Company
      had outstanding stock options to purchase 241,250 and 471,250 shares of common
      stock, respectively. For the six months ended June 30, 2008 and 2007, options
      to
      purchase 80,000, and 50,000 shares, respectively, were excluded from the
      computation of dilutive earnings per share as their effect would have been
      anti-dilutive.




7




**For
                The Three**
              **Months
                Ended**
              **June
                30,**
            
            **For
                The Six**
              **Months
                Ended**
              **June
                30,****2008**
            
            **2007**
            
            **2008**
            
            **2007****(unaudited)**
            
            **(unaudited)**Basic:Net
                (loss) income (attributable to common stock)
            
            $
            (197,980
            )
            $
            72,515
            
            $
            (292,903
            )
            $
            156,879Weighted
                average common shares outstanding
            
            
            2,574,981
            
            
            2,727,190
            
            
            2,574,981
            
            
            2,727,071Basic
                (loss) earnings per share
            
            $
            (0.08
            )
            $
            0.03
            
            $
            (0.11
            )
            $
            0.06Diluted:Net
                (loss) income (attributable to common stock)
            
            $
            (197,980
            )
            $
            75,515
            
            $
            (292,903
            )
            $
            156,879Weighted
                average common shares outstanding
            
            
            2,574,981
            
            
            2,727,190
            
            
            2,574,981
            
            
            2,727,071Dilutive
                effect of stock options
            
            
            -
            
            
            98,750
            
            
            -
            
            
            98,750Weighted
                average common shares outstanding-diluted
            
            
            2,574,981
            
            
            2,825,940
            
            
            2,574,981
            
            
            2,825,821Diluted
                (loss) earnings per share
            
            $
            (0.08
            )
            $
            0.03
            
            $
            (0.11
            )
            $
            0.06





**Income
      Taxes**





The
      Company has elected under Subchapter S of the Internal Revenue Code to be
      treated as an “S Corporation” for tax purposes. Accordingly, items of income and
      loss are taxed to the Company’s stockholders and no provision for income taxes
      is necessary in the financial statements.





**New
      Accounting Pronouncements**





In
      September 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 157, *“Fair
      Value Measurements* ”
(“SFAS
      157”). This statement provides a single definition of fair value, a framework
      for measuring fair value, and expanded disclosures concerning fair value.
      Previously, different definitions of fair value were contained in various
      accounting pronouncements creating inconsistencies in measurement and
      disclosures. SFAS 157 applies under those previously issued pronouncements
      that
      prescribe fair value as the relevant measure of value, except SFAS No. 123(R)
      and related interpretations and pronouncements that require or permit
      measurement similar to fair value but are not intended to measure fair value.
      This pronouncement is effective for fiscal years beginning after November 15,
      2007. The adoption of this standard did not have a material impact on the
      Company’s financial statements.





In
      February 2007, the FASB issued SFAS No. 159, *The
      Fair Value Option for Financial Assets and Financial Liabilities - Including
      an
      amendment of FASB Statement No. 115* ,
      which
      generally permits the measurement of selected eligible financial instruments,
      including investment securities, at fair value as of specified election dates
      and the reporting of unrealized gains or losses on those instruments in earnings
      at each subsequent reporting date. Generally, the fair value option may be
      applied on an instrument by instrument basis, but once applied, the election
      is
      irrevocable and is applied to the entire instrument. The statement is effective
      for fiscal years beginning after November 15, 2007, with early adoption
      permitted as of the beginning of the fiscal year that begins on or before
      November 15, 2007. The adoption of this standard did not have a material impact
      on the Company’s financial statements.





In
      December 2007, the FASB issued SFAS 141(R), “ *Business
      Combinations (Revised 2007)* (“SFAS
      141R”). SFAS 141R replaces SFAS 141, *“Business
      Combinations* ”,
      and
      applies to all transactions and other events in which one entity obtains control
      over one or more other businesses. SFAS 141R requires an acquirer, upon
      initially obtaining control of another entity, to recognize assets, liabilities
      and any non-controlling interest in the acquiree at fair value as of the
      acquisition date. Contingent consideration is required to be recognized and
      measured at fair value on the date of acquisition rather than at a later date
      when the amount of that consideration may be determinable beyond a reasonable
      doubt. This fair value approach replaces the cost-allocation process required
      under SFAS 141 whereby the cost of an acquisition was allocated to the
      individual assets acquired and liabilities assumed based on their estimated
      fair
      value. SFAS 141R requires acquirers to expense acquisition-related costs as
      incurred rather than allocating such costs to the assets acquired and
      liabilities assumed, as was previously the case under SFAS 141. Under SFAS
      141R,
      the requirement of SFAS 146, *“Accounting
      for Costs Associated with Exit of Disposal Activities”* ,
      would
      have to be met in order to accrue for a restructuring plan in purchase
      accounting. Pre-acquisition contingencies are to be recognized at fair value,
      unless it is a non-contractual contingency that is not likely to materialize,
      in
      which case nothing should be recognized in purchase accounting and, instead,
      that contingency would be subject to the probable and estimable recognition
      criteria of SFAS 5, “ *Accounting
      for Contingencies* ”.
      SFAS
      141R is expected to have a significant impact on the Company’s accounting for
      business combinations closing on or after January 1, 2009.





8


In
      December 2007, the FASB issued SFAS No. 160, “ *Noncontrolling
      Interest in Consolidated Financial Statements, an amendment of ARB Statement
      No.
      51* ”
(“SFAS
      160”). SFAS 160 amends Accounting Research Bulletin (ARB) No. 51, “ *Consolidated
      Financial Statements* ”,
      to
      establish accounting and reporting standards for the non-controlling interest
      in
      a subsidiary and for the deconsolidation of a subsidiary. SFAS 160 clarifies
      that a non-controlling interest in a subsidiary, which is sometimes referred
      to
      as a minority interest, is an ownership interest in the consolidated entity
      that
      should be reported as a component of equity in the consolidated financial
      statements. Among other requirements, SFAS 160 requires consolidated net income
      to be reported at amounts that include amounts attributable to both the parent
      and the non-controlling interest. It also requires disclosure, on the face
      of
      the consolidated income statement, of the amount of consolidated net income
      attributable to the parent and to the non-controlling interest. SFAS 160 is
      effective for the Company on January 1, 2009 and is not expected to have a
      significant impact on the Company’s financial statements.





In
      March
      2008, the FASB issued SFAS No. 161, “ *Disclosures
      about Derivative Instruments and Hedging Activities, an amendment of FASB
      Statement No. 133* ”
(“SFAS
      161”). SFAS 161 is intended to enhance the current disclosure framework
      previously required for derivative instruments and hedging activities under
      SFAS
      No. 133, “ *Accounting
      for Derivative Instruments and Hedging Activities* ”,
      to
      include how and why an entity uses derivative instruments, how derivative
      instruments and related hedge items are accounted for and their impact on an
      entity’s financial position, results of operations, and cash flows. This
      standard is effective for fiscal years and interim periods beginning after
      November 15, 2008, with early adoption encouraged. Although the Company does
      not
      currently utilize derivative instruments, it is currently evaluating the impact
      of this new standard on its financial position, results of operations and cash
      flows.





**NOTE
      C— LOANS RECEIVABLE, IMPAIRED LOANS AND ALLOWANCE FOR LOAN LOSSES**




**Loans
      Receivable**





Loans
      receivable are stated as unpaid principal balance net of any deferred fees
      and
      payments in process, less the allowance for loan losses.





Interest
      income from loans receivable is recognized using the interest method whereby
      interest income is recognized using the loan’s effective rate based upon
      outstanding principal. Loan origination fees received from borrowers are
      deferred and amortized into income over the established average life of related
      loans under a method which approximates the effective interest rate method.
      Loan
      premiums and discounts are also amortized into interest income under the same
      method.





The
      Company pays fees to third parties in connection with the acquisition of loans.
      These costs are amortized against interest income over the estimated average
      life of the loans under a method which approximates the effective interest
      rate
      method.





The
      Company incurs direct loan origination costs in its direct lending activities.
      These costs are capitalized and amortized against interest income over the
      estimated average life of the loans under a method which approximates the
      effective interest rate method.





**Impaired
      Loans**





Under
      the
      provisions of SFAS Nos. 114 and 118, *Accounting
      by Creditors for Impairment of a Loan* ,
      a loan
      is considered impaired (or nonaccrual) if it is probable that the company will
      not collect all principal and interest payments according to the loan’s
      contracted terms. The impairment of the loan is measured at the present value
      of
      the expected cash flows using the loan’s effective interest rate, or the loan’s
      observable market price. Interest income generally is not recognized on specific
      impaired loans unless the likelihood of further loss is remote. Interest
      payments received on such loans are applied as a reduction of the loan’s
      principal balance. Interest income on the other nonaccrual loans is recognized
      only to the extent of interest payments received.




9


Information
      with respect to impaired loans and the related allowance for loan losses is
      shown below:





**June
                30,**
              **2008**
            
            **December
                31,**
              **2007****(unaudited)**Total
                recorded investment in impaired loans
            
            $
            3,031,006
            
            $
            510,697Amount
                of that recorded investment for which there is a related allowance
                for
                loan losses
            
            $
            1,765,525
            
            $
            510,697Amount
                of related allowance for loan losses associated with such
                investment
            
            $
            430,927
            
            $
            306,815Amount
                of that recorded investment for which there is no related allowance
                for
                loan losses
            
            $
            1,265,481
            
            $
            -





**For
                the six months**
              **ended
                June 30,**
              **2008**
            
            **For
                the year**
              **ended
                December 31,**
              **2007****(unaudited)**Average
                recorded investment in impaired loans during period
            
            $
            1,770,851
            
            $
            581,296Related
                amount of interest income recognized within period when loans were
                impaired
            
            $
            -
            
            $
            -Amount
                of income recognized using cash basis during time within period that
                loan
                was impaired
            
            $
            -
            
            $
            -





At
      June
      30, 2008 and December 31, 2007, the Company had loans of $2,979,512 and
      $5,002,259, respectively, which were more than 90 days past due and for which
      the Company continues to accrue interest. The Company believes that these loans
      are adequately secured and that both the principal and the related accrued
      interest are collectible.





Analysis
      of the allowance for loan losses is as follows:





**For
                the six months**
              **ended
                June 30,**
              **2008**
            
            **For
                the six months**
              **ended
                June 30,**
              **2007****(unaudited)**
            
            **(unaudited)**Beginning
                balance
            
            $
            495,480
            
            $
            452,154Provision
                for loan losses
            
            
            154,098
            
            
            120,000Loans
                charged off, net
            
            
            (57,454
            )
            
            (152,638
            )Ending
                Balance
            
            $
            592,124
            
            $
            419,516





**NOTE
      D—INVESTMENTS**





Other
      investments available for sale of $25,437 at June 30, 2008 and December 31,
      2007
      consist of an equity investment in a private company. The cost of this
      non-marketable security approximates the fair value of this
      investment.





**NOTE
      E—RELATED PARTY TRANSACTIONS**





Included
      in notes receivable at June 30, 2008 and December 31, 2007, are 12 notes
      totaling $10,649,676 and 12 notes totaling $10,694,192, respectively, from
      officers, stockholders and entities controlled by a stockholder. 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%.
      The majority (94.4%) of these notes receivable were due from one stockholder
      and
      its related interests, who owed $10,058,501 as of June 30, 2008.





Included
      in the notes payable and other loans payable balances at June 30, 2008 and
      December 31, 2007, are 63 notes totaling $7,112,362 and 66 notes totaling
      $11,437,449, respectively, which are held by officers and stockholders. These
      notes were issued at the rates in effect for the applicable terms selected
      as of
      the date the notes were issued.





During
      the six months ended June 30, 2008, the Company had short-term net borrowings
      of
      $494,540 from ten stockholders and holders of investment notes. These borrowings
      are included with Other Loans Payable on the balance sheet. These loans are
      unsecured and due and payable upon demand.





10


There
      is
      a note receivable of $185,450 included in other receivables, shown on the
      balance sheet at June 30, 2008 and December 31, 2007 as contra-equity, made
      to
      the Company’s CEO for the purchase of 100,000 shares of stock in the Company,
      which secures the loan. The interest rate on this loan is seven percent. At
      June
      30, 2008 and December 31, 2007, all payments under this loan had been timely
      made and there was no accrued interest receivable on this loan.





Included
      in the notes receivable at June 30, 2008 are six loans in the amount of
      $10,058,501 to a trust for the benefit of a significant stockholder. The
      majority of these loans ($9.75 million) were made prior to the period ending
      December 31, 2007. The proceeds of these loans were used to purchase real estate
      which serves as security for the loans. The Company holds a first or second
      lien
      position with respect to the collateral securing approximately $9.75 million
      of
      these loans as well as other real and personal collateral . The loans bear
      interest at 8% per annum and have some variable up-side features. Additional
      interest is earned on certain loans if the rental income the borrower receives
      from the property exceeds certain allowable expenses. In addition, upon the
      sale
      of certain real property(ies) (or components thereof), the Company is to receive
      one quarter or one-half, depending on the specific property, of any gain after
      adjusting for certain costs and commissions. The loans do not have any variable
      down-side features which would cause interest to be lower than the stated rate
      on each loan. Under the terms of the loans any refinancing or sale of the
      properties must be approved by the Company in advance. During the six months
      ended June 30, 2008 and 2007, the Company recognized $0 in additional interest
      from the above loan features. The Company recognizes such additional interest
      earned through variable up-side loan features only when the additional interest
      is collected.





Management
      believes that all of the above transactions were consummated on substantially
      the same terms, including interest rates and collateral, as those prevailing
      for
      comparable transactions with other customers.





During
      the six months ended June 30, 2008, the Company purchased 150,000 shares of
      its
      common stock held by Robert L. Harris, Chief Executive Officer and President,
      at
      $2.00 per share, for a total of $300,000.





**NOTE
      F—** **STOCK
      BASED COMPENSATION**





The
      Company has granted stock-based compensation awards to employees and directors.
      Awards may consist of common stock or stock options. The Company’s stock options
      have five-year terms and vest over three years in three equal annual
      installments. The stock options provide for option exercise prices equal to
      or
      greater than the fair market value of the common stock at the date of the grant,
      as determined by the Board on the grant date.





No
      stock
      options were granted during the six months ended June 30, 2008 or 2007. The
      Company accrues related compensation expenses as its options vest in accordance
      with SFAS 123(R), *Share-Based
      Payment.* The
      Company recognized $7,792 and $11,500 stock-based compensation expense during
      the six months ended June 30, 2008 and 2007, respectively, from the vesting
      of
      stock options issued in earlier periods. Stock-based compensation includes
      the
      value of stock granted to directors for their service, which was $0 and $0,
      respectively, for the six months ended June 30, 2008 and 2007.





A
      summary
      of stock option activity during the six months ended June 30, 2008 and related
      information is included in the table below:





**Number
                of Options**
            
            **Weighted-Average**
              **Exercise
                Price**
            
            **Weighted-Average**
              **Remaining**
              **Contractual
                Life**
              **(in
                years)**
            
            **Aggregate**
              **Intrinsic
                Value**Outstanding
                at January 1, 2008
            
            
            241,250
            
            $
            2.39
            
            
            
            
            $
            -Granted
            
            
            -Exercised
            
            
            -Forfeited
                or expired
            
            
            -
            
            
            
            
            
            
            
            
            -Outstanding
                at June 30, 2008
            
            
            241,250
            
            
            2.39
            
            
            1.84
            
            
            -Exercisable
                at June 30, 2008
            
            
            187,917
            
            
            2.17
            
            
            1.50
            
            
            -




11




**NOTE
      G—FAIR VALUE MEASUREMENTS**


SFAS
        No. 157, *Fair
        Value Measurement* ,
        defines
        fair value, establishes a framework for measuring fair value, establishes
        a
        three-level valuation hierarchy for disclosure of fair value measurement
        and
        enhances disclosure requirements for fair value measurements. The valuation
        hierarchy is based upon the transparency of inputs to the valuation of an
        asset
        or liability as of the measurement date. The three levels are defined in
        terms
        of those inputs as follow:
 
 Level
                  1
              Quoted
                  prices (unadjusted) in active markets for identical assets or
                  liabilities;Level
                  2
              Significant
                  inputs other than quoted prices included within Level 1 that are
                  either
                  directly or indirectly observable;Level
                  3
              Significant
                  unobservable inputs in which little or no market activity exists,
                  therefore requiring an entity to develop its own assumptions about
                  the
                  assumptions that market participants would use in
                  pricing.
  Impaired
        Loans
  The
        Company does not record loans at fair value on a recurring basis, however,
        from
        time to time, a loan is considered impaired and an allowance for loan loss
        is
        established. Loans for which it is probable that payment of interest and
        principle will not be made in accordance with the contractual terms of the
        loan
        are considered impaired. Once a loan is identified as individually impaired,
        management measures impairment in accordance with SFAS 114, “Accounting by
        Creditors for Impairment of a Loan,” (SFAS 114). The fair value of impaired
        loans is estimated using one of several methods, including the collateral
        value,
        market value of similar debt, enterprise value, liquidation value and discounted
        cash flows. Those impaired loans not requiring a specific allowance represents
        loans for which the fair value of expected repayments or collateral exceed
        the
        recorded investment in such loans. At June 30, 2008, substantially all of
        the totally impaired loans were evaluated based upon the fair value of the
        collateral. In accordance with SFAS 157, impaired loans where an allowance
        is
        established based on the fair value of collateral require classification
        in the
        fair value hierarchy. When the fair value of the collateral is based on an
        observable market price or a current appraised value, the Company records
        the
        loan as nonrecurring Level 2. When an appraised value is not available or
        management determines the fair value of the collateral is further impaired
        below
        the appraised value and there is no observable market price, the Company
        records
        the loan as nonrecurring Level 3.
  Assets
        and Liabilities Recorded at Fair Value on a Recurring Basis
  The
        table
        below presents the recorded amount of assets and liabilities measured at
        fair
        values on a recurring basis as of June 30, 2008:
 **Assets:**
                
                **Carrying
                    Value**
                  **(Fair
                    Value)**
                
                **Quoted
                    Prices(Level 1)**
                
                **Significant
                    Other Observable Inputs(Level 2)**
                
                **Significant
                    Unobservable Inputs (Level 3)**Investments
                    Available for Sale
                
                $
                25,437
                
                $
                -
                
                $
                25,437
                
                $
                -
 Assets
          and Liabilities Recorded as Fair Value on a Nonrecurring
          Basis
  We
        may be
        required from time to time, to measure certain assets at fair value on a
        nonrecurring basis in accordance with U.S. generally accepted accounting
        principles. These include assets that are measured at the lower of cost or
        market that were recognized at fair value below cost at June 30, 2008. Assets
        measured at fair value on a nonrecurring basis are included in the table
        below:
 
 **Assets:**
              
              **Carrying
                  Value**
                **(Fair
                  Value)**
              
              **Quoted
                  Prices(Level 1)**
              
              **Significant
                  Other Observable Inputs(Level 2)**
              
              **Significant
                  Unobservable Inputs (Level 3)**Impaired
                  Loans
              
              $
              3,031,006
              
              $
              -
              
              $
              3,031,006
              
              $
              -Other
                Real Estate
                Owned -Held
                  for sale
              
              $
              1,889,402
              
              $
              -
              
              $
              1,889,402
              
              $
              -


**NOTE
      H—COMMITMENTS AND CONTINGENT LIABILITIES**





**Off-Balance
      Sheet Arrangements**




The
      Company enters into off-balance sheet arrangements in the normal course of
      its
      business. These arrangements consist primarily of lines-of-credit and draw-type
      loans. At June 30, 2008, the Company had $4.87 million in loans of this type.
      The unused or unfunded amount on these types of loans totaled $1.11 million
      as
      of June 30, 2008.





**Item
      2. Management’s Discussion and Analysis of Financial Condition and Results of
      Operations.**





Portions
      of this report contain “forward-looking statements,” as that term is defined in
      the Private Securities Litigation Reform Act of 1995. Such forward-looking
      statements are based on management’s expectations, estimates, projections and
      assumptions. These statements may be identified by the use of forward-looking
      words or phrases such as “should”, “expects”, “anticipates”, “plans”,
“believes”, “estimates”, “might result”, “projects” and variations of such words
      and similar expressions. 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.
      Such risks and uncertainties include liquidity risks associated with our
      investor notes payable on demand by the holders, other loans and short-term
      borrowings, delinquencies in our loan portfolio, capital levels, changes in
      market interest rates, inability to generate new loans, and competitive factors
      in our marketplace. These risks and uncertainties are described in detail in
      the
      Company’s Annual Report on Form 10-KSB for the year ended December 31, 2007.
      Readers are cautioned not to place undue reliance on such forward looking
      statements, which speak only as of the date of this report. Except as required
      by law, KH Funding Company assumes no obligation to update any forward looking
      statements even if experience or future changes make it clear that projected
      results expressed or implied in such statements will not be
      realized.





The
      information contained in this report pertains to the registrant, KH Funding
      Company. References to the “Company,” “KH Funding” or “we,” “our” and “us” refer
      to KH Funding Company.





**Recent
      Developments**





Our
      ability to engage in business is dependent, in part, on our ability to raise
      funds through the sale of our investor notes. On August 4, 2008, we filed a
      post-effective amendment number 4 to our most recent registration statement
      covering our investor notes with the SEC and several state securities
      regulators. Before we can offer or sell any of our notes in or from a particular
      state, however, the amended registration statement must be declared effective
      by
      the SEC and the applicable state securities regulators. These regulators have
      the ability to review the amended registration statement and, if they deem
      appropriate, issue comments to us and require revisions before they declare
      it
      effective. We filed this amended registration statement with the states pursuant
      to “registration by coordination” provisions of state securities laws, which
      means that, generally, it automatically becomes effective in the states once
      the
      SEC declares it effective. If, however, a state securities regulator determines
      that our amended registration statement does not meet that state’s substantive
      requirements for registration, we may have to revise or amend our amended
      registration statement before it is declared effective in that state, and this
      event would likely delay our offering in that state and/or in other states.
      Our
      amended registration statement has not yet been declared effective by the SEC
      or
      any state securities regulator. As part of our most recent filing, we addressed
      comments issued by both the SEC and the Maryland Securities Division with
      respect to our previous amendment to the registration statement, and each of
      these regulators, or any other state regulator, may decide to issue additional
      comments to which we may be required to respond before our amended registration
      statement is declared effective.





As
      disclosed previously, the Division
      of Securities of the Office of the Maryland Attorney General (the “Maryland
      Securities Division”) is currently investigating the actions of a former Senior
      Vice President who allegedly engaged in unlawful conduct. Specifically, the
      Maryland Securities Division believes that this former Senior Vice President
      (i)
      misappropriated funds from an investor between 2004 and 2006 that the investor
      tendered to him for deposit into her account at the Company and (ii) acted
      as an
      unregistered issuer agent of the Company. During the second quarter of 2008,
      we
      also learned that the Maryland Securities Division is investigating whether
      this
      former Senior Vice President may have funded an investor account at the Company
      with funds that he obtained unlawfully from a third party in a personal
      transaction. These matters are described in more detail in Item I of Part II
      of
      this report. Although we believe we are close to finalizing this investigation,
      there can be no guarantee as to when this investigation will be finalized or
      its
      outcome. We anticipate that the Maryland Securities Division may require us
      to
      pay a civil money penalty. This investigation and its outcome may impede our
      ability to offer and sell our investor notes.





12


**Overview**





We
      conduct mortgage banking operations from our headquarters in Silver Spring,
      Maryland. Our primary business activities consist of originating, acquiring
      and
      servicing mortgage and business loans. We emphasize the direct origination
      of
      small commercial real estate mortgage loans and investment property residential
      mortgage loans. We also purchase first and second mortgage loans secured by
      residential real estate from other lenders and banks around the country. Over
      the past few years, our lending activities have focused primarily on purchasing,
      rather than originating, loans. This strategy is aimed at enabling us to expand
      our operations with a limited amount of additional personnel and expense because
      we anticipate that only a minimal expansion of our administrative functions
      will
      be needed to support an increased wholesale component in our operations. We
      plan
      to identify and utilize additional brokers, lenders and banks as sources for
      our
      loan acquisitions.





Prior
      to
      2007, our business activities consisted of purchasing mortgage loans (80% of
      our
      business) and of originating, acquiring and servicing mortgage loans (20% of
      our
      business). Since 2007, our business activities have been limited to funding
      existing lines of credit and draw-down loan and otherwise servicing our existing
      loan portfolio. To fund our operations and to satisfy our obligations under
      our
      outstanding investor notes, including redemption requests, we have traditionally
      relied on (i) funds received from loan pay-offs, (ii) interest and other fee
      income received on our loans, and (iii) funds raised through the issuance of
      interest-bearing debt securities to investors. However, we have not had the
      ability to publicly issue securities since the second quarter of 2006, so our
      operations have recently been funded solely through loan pay-offs, interest
      and
      other income received on our loans, and unsecured short-term borrowings. Once
      we
      are able to raise funds through the sale of our investor notes, we intend to
      again focus on purchasing, making and acquiring new mortgage loans.





Our
      net
      income depends largely upon our net interest income, which is the difference
      between interest income we earn from our loans and investments, referred to
      as
      interest-earning assets, and interest expense that we pay 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.





Starting
      in the fourth quarter of 2004, we expanded the distribution for our investor
      notes by engaging in strategic alliances with several major financial services
      firms throughout the country. We currently have signed selling agreements with
      three broker-dealers registered with The Financial Industry Regulatory Authority
      (“FINRA”), with a network of over 1,200 registered representatives in the
      Midwest and West. These alliances have given us the ability to sell our investor
      notes through a network of financial intermediaries in defined geographic
      locations. Through the middle of 2006, our distribution plan has been very
      successful, establishing close to 700 new investment accounts providing us
      with
      over $25,000,000 in funds. In 2006, sales by these broker-dealers established
      approximately 522 new investment accounts and provided over $11 million in
      funds. We plan to further increase our distribution network, and are currently
      in negotiations with other FINRA-registered broker-dealers interested in
      distributing our investor notes in parts of the United States where we are
      not
      currently represented.





As
      reported in our Annual Report on Form 10-KSB for the year ended December 31,
      2007, our business strategy has been hampered in recent years because of our
      inability to raise funds through the sale of our investor notes in or from
      Maryland, our largest market. As discussed above, we recently filed an amendment
      to our latest registration statement covering investor notes with the SEC and
      several state securities regulators and anticipate that we will soon be able
      to
      renew our selling efforts, although there is no guarantee that this amended
      registration statement will be declared effective when anticipated, if at
      all.





Recently,
      the sub-prime mortgage lending environment has experienced considerable strain
      from rising delinquencies and liquidity pressures. Several high profile
      sub-prime mortgage lenders have failed. These market conditions have resulted
      in
      increased scrutiny of sub-prime lending practices. Although we make and acquire
      loans that may be considered “sub-prime loans”, we believe that our exposure to
      problems in the industry is limited as a result of several factors.





First,
      at
      June 30, 2008 our sub-prime loans amounted to only $4.24 million, or 9.96%
      of
      our total loans.





Second,
      we believe that we underwrite our sub-prime loans to a higher standard than
      that
      employed by some of the more aggressive lenders. Our underwriting standards
      address approval limits, loan-to-value ratios, appraisal requirements, debt
      service coverage ratios, loan concentration limits and other matters relevant
      to
      loan underwriting.





Third,
      we
      do not offer or purchase the types of sub-prime loans that are receiving the
      harshest criticism from regulators, commentators and Congress. Notably, as
      a
      general matter, the sub-prime loans that we originate and purchase have loan
      to
      value (“LTV”) ratios that are less than 70%, as opposed to ratios of 95% or
      higher allowed by many sub-prime lenders. In addition, we do not offer so-called
      “teaser” rate adjustable loans, low or no document or “stated income” loans.





13


Fourth,
      we do not generate or purchase high volumes of sub-prime loans, so we are able
      to look much more closely at the ability of individual borrowers to repay their
      loans. In the case of purchased loans, we rely on strict purchase criteria
      relating to LTV ratios and documentation.





Notwithstanding
      the foregoing, because we do carry some sub-prime loans, we are subject to
      some
      exposure to losses. For example, if there were to be a major downturn in real
      estate values in the markets in which our sub-prime borrowers reside and those
      borrowers were to default, the collateral securing these loans might not be
      sufficient to fully repay the loan balances.





**Critical
      Accounting Policies**





Our
      significant accounting policies are disclosed in Note A to the audited financial
      statements included in our Annual Report on Form 10-KSB for the year ended
      December 31, 2007. Management believes the following significant accounting
      policies also are considered critical accounting policies:





*Loan
      Impairment* - A loan
      is considered impaired when, based on available information or current events,
      it is probable that we will be unable to collect scheduled payments of principal
      and interest when due according to the contractual terms of the loan agreement.
      Factors considered in determining impairment include payment status, collateral
      value, and the probability of collecting scheduled principal and interest
      payments when due. Loans that experience insignificant payment delays and
      payment shortfalls generally are not considered impaired. We measure impairment
      on a loan by loan basis using the present value of expected future cash flows
      discounted at the loan’s effective interest rate, the loan’s obtainable market
      value, or the fair value of the collateral if the loan is collateral-dependent.
      However, impairment is based on the fair value of the collateral if it is
      determined that the foreclosure is probable.





*Allowance
      for Loan Losses* - We
      periodically evaluate the adequacy of the allowance for loan losses based on
      past loan loss experience, known and inherent risks in the portfolio, adverse
      situations that might affect the borrower’s ability to repay, the estimated
      value of any underlying collateral, and current economic conditions. While
      we
      use information available in establishing the allowance for loan losses,
      evaluation assessments are inherently subjective and future adjustments to
      the
      allowance may be necessary if economic conditions differ substantially from
      the
      assumptions used in making the evaluation. The allowance for loan losses is
      a
      material estimate that is particularly susceptible to significant change in
      the
      near term.





**Comparison
      of Financial Condition at June 30, 2008 and December 31,
      2007**





*Assets* .
      Total
      assets decreased by $4,791,048, from $53,392,939 at December 31, 2007 to
      $48,601,891 at June 30, 2008. The size of our loan portfolio decreased
      $5,310,437 ending at $42,574,751. The decrease in total assets resulted
      primarily from our inability to sustain historical loan growth due to a shortage
      in cash because of our inability to sell our investor notes and the use of
      loan
      payoff proceeds to fund investor note redemption requests.





*Liabilities* .
      Total
      liabilities decreased by $4,205,987, from  $52,353,873
      at December 31, 2007 to $48,147,886 at June 30, 2008. The net decrease was
      primarily due to $11,191,349 in investor note redemptions, offset by an increase
      of $4,438,611 in loan participations sold.





*Equity* .
      Total
      stockholders’ equity decreased by $585,111 from $1,039,066 at December 31, 2007
      to $453,955 at June 30, 2008. The decrease was due to a net loss of $292,903
      related primarily to a decrease in net interest income because of a decrease
      in
      interest earning assets and a reduced net margin, as well as to stock-based
      compensation of $7,791 and the repurchase of 150,000 shares of stock at $2.00
      per share.





*Past
      Due Loans* .
      As of
      June 30, 2008, we held 14 loans that were more than 90 days past due but still
      accruing interest, compared to 18 as of December 31, 2007. The total principal
      and interest due on these loans was $2,979,512, compared to $5,002,259 as of
      December 31, 2007. Seven of the loans, totaling $1,082,655, are first mortgage
      loans on which we do not expect to suffer any loss due to the underlying
      collateral values. The borrowers under the remaining 7 loans, totaling
      $1,896,857, are making scheduled payments, and we continue to accrue interest
      on
      these loans based on the underlying collateral values and payment histories.
      We
      monitor these loans on a continuous basis.





*Non-Accrual
      Loans* .
      As of
      June 30, 2008, there were 15 loans in non-accrual status with an outstanding
      principal balance totaling $3,031,332, compared to 13 loans as of December
      31,
      2007 with an outstanding principal balance of $510,697. The majority of these
      loans are first mortgage loans that management believes are well-collateralized
      based on recent valuations. In the event we have to foreclose on any of these
      loans, we do not expect to recognize any loss in excess of specific reserves
      associated with the loans. As of June 30, 2008, we had a specific reserve of
      $430,927 and a general reserve of $161,197 as part of our total reserve of
      $592,124 for anticipated and unanticipated loan losses.





14


**Comparison
      of Operating Results for Six Months Ended June 30, 2008 and
      2007**





*Net
      interest margin.* The
      average yield earned on loans receivable was 10.02% for the six months ended
      June 30, 2008 and 10.87% for the six months ended June 30, 2007. The average
      rate paid on investor notes decreased to 6.78% for the six months ended June
      30,
      2008 from 6.91% for the six months ended June 30, 2007, due primarily to an
      decrease in the contractual rates we are required to pay on investor notes
      and
      redemptions on our lower-cost notes. Overall, the net margin on interest
      decreased to 3.24% for the six months ended June 30, 2008, from 3.64% for the
      six months ended June 30, 2007. This net margin is calculated using contractual
      rates and excludes fee income and expense.





*Net
      Income/Loss* .
      Net
      loss for the six months ended June 30, 2008 was $292,903, compared to net income
      of $156,879 for the six months ended June 30, 2007. The difference was primarily
      due to a decrease in net interest income because of a decrease in interest
      earning assets and a reduced net margin.





*Interest
      Income* .
      Total
      interest income was $2,266,525 for the six months ended June 30, 2008, compared
      to $3,072,497 for the same period in 2007. The decrease in interest income
      was
      due primarily to a decrease of $781,611 in interest earned on loans between
      the
      two periods because a significant amount of our higher-rate loans have been
      paid
      off. The decrease in interest earned on loans also resulted from a decline
      in
      our loans receivable portfolio due to normal payoffs and a lack of loan
      originations and purchases. Interest income includes loan and fee income and
      interest earned on bank investments and marketable securities.





*Interest
      Expense* .
      Interest expense was $1,841,952 for the six months ended June 30, 2008, and
      $2,154,258 for the corresponding period in 2007. The decrease in interest
      expense was a result of a decrease in total investor notes payable due to
      increased redemptions during the period. The interest expense includes the
      amortization of fees paid to Brokers-Dealers in prior periods for the sale
      of
      investor notes.





*Provision
      for Loan Losses* .
      Our
      provision for loan losses was $154,098 for the six months ended June 30, 2008,
      compared to $120,000 for the six months ended June 30, 2007. These provisions
      increased the allowance for loan losses 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 $52,886 during the six months ended June 30, 2008,
      compared to $23,353 for the corresponding period in 2007. The difference was
      primarily due to an increase of $19,522 from rental income earned on other
      real
      estate owned.





*Non-Interest
      Expense* .
      Non-interest expense decreased to $616,264 for the six months ended June 30,
      2008 from $664,713 for the six months ended June 30, 2007. The decrease was
      due
      to a reduction in salaries and wages, securities offering costs and real estate
      maintenance expenses.





*Income
      Taxes* .
      We have
      elected to be treated as a Subchapter S corporation under the Internal Revenue
      Code and, accordingly, no income tax expense appears in our financial
      statements.




**Comparison
      of Operating Results for Three Months Ended** **June
      30, 2008 and 2007**




*Net
      interest margin.* The
      average yield earned on loans receivable was 9.69% for the three months ended
      June 30, 2008 and 10.56% for the three months ended June 30, 2007. The average
      rate paid on investor notes decreased to 6.64% for the three months ended June
      30, 2008 from 6.76% for the three months ended June 30, 2007, due primarily
      to
      an increase in the contractual rates we are required to pay on investor notes.
      Overall, the net margin on interest decreased to 3.05% for the three months
      ended June 30, 2008, from 3.80% for the three months ended June 30, 2007. This
      net margin is calculated using contractual rates and excludes fee income and
      expense. The current net margin of 3.05% is at its historical low. The Company
      does not expect any further significant decrease.




*Net
      (Loss) Income* .
      Net
      loss for the three months ended June 30, 2008 was $197,980 compared to net
      income of $72,515 for the three months ended June 30, 2007. The difference
      was
      primarily due to a decrease in net interest income because of a decrease in
      interest earning assets and a reduced net margin.




15


*Interest
      Income* .
      Total
      interest income was $1,052,343 for the three months ended June 30, 2008,
      compared to $1,539,952 for the same period in 2007. The decrease in interest
      income resulted from a decrease in total loan portfolio due to loan payoffs
      and
      lack of loan originations. In addition, we had an increase in nonaccrual loans
      in the period. The interest income includes point and fee income and
      interest earned on bank investments and marketable securities.




*Interest
      Expense* .
      Interest expense was $872,472 for the three months ended June 30, 2008 and
      $1,069,941 for the corresponding period in 2007. The decrease in interest
      expense was due to a reduction in 2008 in interest rates and a reduction in
      total Investor notes payable due to redemptions. The interest expense includes
      the amortization of fees paid to Brokers-Dealers in prior periods for the sale
      of investor notes.




*Provision
      for Loan Losses* .
      Our
      provision for loan losses was $75,000 for the three months ended June 30, 2008
      and June 30, 2007. These provisions increased the allowance for loan losses
      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 $23,217 during the three months ended June 30, 2008,
      compared to $6,280 for the corresponding period in 2007. The difference was
      primarily due to the more recent period having smaller losses on the sale of
      other real estate owned and increased rental income during the
      period.




*Non-Interest
      Expense* .
      We
      experienced a slight decrease in non-interest expense to $326,068 for the three
      months ended June 30, 2008 from $328,776 for the three months ended June 30,
      2007. Decreases in salaries and wages and real estate maintenance costs were
      offset by increases in professional fees and various administration costs in
      the
      current period as compared to the prior period.




*Income
      Taxes* .
      We have
      elected to be treated as a Subchapter S corporation under the Internal Revenue
      code and accordingly no income tax expense appears in the financial
      statements.





**Liquidity
      and Capital Resources**





For
      the
      six months ended June 30, 2008, net cash provided by operating activities was
      $2,083,319, compared to $1,184,792 for the period ended June 30, 2007. The
      primary reason for the increase was a $1,073,347 reduction in interest
      receivable on loans as a result of loan pay-offs during the period ended June
      30, 2008, compared to an increase of $340,475 in interest receivable on loans
      during the period ended June 30, 2007.





For
      the
      six months ended June 30, 2008, net cash provided by investing activities was
      $3,591,284, compared to $1,270,193 for the same period in 2007. Cash provided
      by
      investing activities for the six months ended June 30, 2008 included $9,291,650
      in principal repayments on loans receivable offset by $5,199,922 in loans made
      to borrowers, compared to $7,127,337 and $6,669,592, respectively, for the
      six
      months ended June 30, 2007.





For
      the
      six months ended June 30, 2008, net cash used in financing activities was
      $5,561,001, compared to $5,645,919 for the same period in 2007. Net proceeds
      from loan participations sold of $4,438,611 were offset by $11,191,349 in
      investor note redemptions and $300,000 in stock repurchases.





Historically,
      our primary sources of funding have been the proceeds from the sale of investor
      notes, principal and interest payments received on loans receivable and
      investments, proceeds from the sale of loans and rental income from real estate
      owned and held for rental. While maturities and scheduled amortization of loans
      receivable 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.
      Redemption requests from holders of our one-day and thirty day demand investor
      notes can cause significant volatility in our cash balances. We attempt to
      mitigate this volatility through our liquidity strategy discussed
      below.





During
      the six month period ending June 30 2008, we received approximately $12,631,444
      of principal and interest in loan payments, which included unscheduled
      prepayments and payments due at maturity. Beginning in the second quarter of
      2006 and continuing through the second quarter of 2008, however, we have been
      unable to sell our investor notes due to delays in obtaining an effective
      registration covering our investor notes. Although we continue to pursue our
      registration efforts, the amended registration statement that we filed with
      the
      SEC and various state securities regulators has not yet been declared effective.
      Although we anticipate that our amended registration statement will be declared
      effective soon, we cannot guarantee that this will happen. Until we are able
      to
      raise funds through the sale of investor notes, our funding sources will be
      limited to payments received on our loans, proceeds from the sale of loan
      participations, and proceeds from the sale of loans.





16


One
      of
      our primary liquidity needs is the funding of redemption requests on our one-day
      demand and thirty-day demand investor notes. Holders of one-day demand notes
      can
      make redemption requests by giving us one day prior notice. Holders of thirty
      day demand notes can make redemption requests by giving us 30 days’ prior
      notice. All other types of investor notes, that is the one, three and five
      year
      fixed-rate notes, are redeemable upon maturity, or prior to maturity on 90
      days’
advance notice with an early redemption penalty.





We
      make
      an effort to keep funds available for redemption requests related to our one
      day
      demand notes and, in prior periods, have always attempted to hold 5% to 20%
      of
      our total assets in cash and cash equivalents to fund redemptions. This amount
      has historically been sufficient for us to meet these obligations. At June
      30,
      2008, however, we had cash and cash equivalents of $209,224.





As
      stated
      elsewhere in this report, our ability to sell our investor notes in our
      principal markets during 2006, 2007 and the first half of 2008 was very limited
      due to delays in registering this offering. Our cash and cash equivalents,
      which
      is the primary source of funds to pay interest on and redeem our investor notes,
      have been significantly impacted by this delay. At June 30, 2008, cash and
      cash
      equivalents were $209,224, or 0.43% of total assets, a historically low level,
      compared to $95,622 at December 31, 2007. Overall our low cash balances are
      due
      to the fact that redemptions of our investor notes during the first half of
      2008
      and fiscal year 2007 exceeded sales of investor notes during those periods
      due
      to our limited ability to sell investor notes.


During
      2007, we accepted loans (Other loans payable) from some of our existing security
      holders in the net amount of $.70 million.





In
      those
      instances in which we believe funds necessary to satisfy redemption requests
      will not be available when required, we attempt to sell loans receivable from
      our portfolio. However, any sale of loans must comply with the requirements
      of
      the Trust Indenture Act of 1939 and may require the consent of the trustee
      for
      investor notes. At June 30, 2008, we held more than $26 million in residential
      and commercial mortgage loans that we believe could be sold within a short
      period of time for the purpose of satisfying investor note redemption requests.
      Further, we held $3.75 million in business line-of-credit loans and second
      lien
      loans at June 30, 2008, which earn higher yields than the first trust loans
      and
      that we believe could also be sold, although generally they take longer to
      sell
      and are sold at a discount. It should be noted, however, that the national
      and
      local real estate economies have weakened during the past two years in part
      due
      to the widely-reported problems in the sub-prime mortgage loan market. These
      problems have had the effect of decreasing the amount of credit that is
      available to borrowers. As a result, sellers of real estate and loans secured
      by
      real estate have found it more difficult in recent years to sell their assets
      at
      the times and at the prices they desire. Because of these legal and market
      factors, we may not be able to sell loans from our portfolio to meet redemption
      requests. If we are unable to obtain funds to meet a redemption request within
      30 days of such request, we would be in default under the note, which would
      permit, but not require, the indenture Trustee to accelerate the maturity of
      the
      note, declare all of our outstanding investor notes immediately due and payable,
      and take other actions permitted by the indenture for the investor notes.





At
      June
      30, 2008, we had outstanding one day demand notes of $6,084,854 and outstanding
      thirty day demand notes of $9,073,918 million. The maturities of our outstanding
      investor notes at June 30, 2008 are as follows:




**Series
                3 Demand Notes**
            
            **Balance**One
                Day
            
            $
            6,084,854Thirty
                Day
            
            $
            9,073,918**Series
                3 Fixed Term Notes:**Due
                within 1 year
            
            $
            7,535,821Due
                in 1 to 3 years
            
            $
            5,893,800Due
                in 3 to 5 years
            
            $
            6,938,435**Series
                4 Fixed Term Notes:**Due
                within 1 year
            
            $
            1,804,166Due
                in 1 to 3 years
            
            $
            348,227Due
                in 3 to 5 years
            
            $
            4,478,530


Subtotal
            
            $
            42,157,751Unamortized
                brokerage costs
            
            
            (98,783
            )Total
                investor notes, net
            
            $
            42,058,968





We
      have
      never failed to satisfy a redemption request within the 30-day grace period
      stated above. Notwithstanding this historical track record, there can be no
      guarantee that we be able to maintain sufficient liquidity to meet future
      redemption requests.


17


**Known
      Trends, Events of Uncertainties**





*Impact
      of Inflation and Interest Rates* .
      The
      financial statements of the Company 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 the Company to its borrowers. Unlike
      typical industrial companies, nearly all the assets and liabilities of the
      Company 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
      seven years, from 10.6% at December 31, 1999 to 0.93% at June 30, 2008. During
      the period ending June 30, 2008, we experienced an operating loss of $292,903
      combined with stock repurchases of $300,000 resulting in an ending balance
      in
      stockholders equity of $453,955. Our Board suspended the payment of stock
      dividends after the second quarter of 2007 to help maintain sufficient equity
      levels.





**Item
      4T. Controls and Procedures.**





We
      maintain disclosure controls and procedures that are designed to ensure that
      information required to be disclosed in our reports filed under the Securities
      Exchange Act of 1934 with the SEC, such as this Quarterly Report, is recorded,
      processed, summarized and reported within the time periods specified in those
      rules and forms, and that such information is accumulated and communicated
      to
      Management, including the Chief Executive Officer, who also serves as the acting
      Chief Financial Officer (“CFO”), to allow for timely decisions regarding
      required disclosure. A control system, no matter how well conceived and
      operated, can provide only reasonable, not absolute, assurance that the
      objectives of the control system are met. Further, the design of a control
      system must reflect the fact that there are resource constraints, and the
      benefits of controls must be considered relative to their costs. These inherent
      limitations include the realities that judgments in decision-making can be
      faulty, and that breakdowns can occur because of simple error or mistake.
      Additionally, controls can be circumvented by the individual acts of some
      persons, by collusion of two or more people, or by management override of the
      control. The design of any system of controls also is based in part upon certain
      assumptions about the likelihood of future events, and there can be no assurance
      that any design will succeed in achieving its stated goals under all potential
      future conditions; over time, controls may become inadequate because of changes
      in conditions, or the degree of compliance with the policies or procedures
      may
      deteriorate.





An
      evaluation of the effectiveness of these disclosure controls as of June 30,
      2008
      was carried out under the supervision and with the participation of Management,
      including the CEO. Based on that evaluation, the Company’s management, including
      the CEO, has concluded that our disclosure controls and procedures are, in
      fact,
      effective at the reasonable assurance level.





During
      the second quarter of 2008, we strengthened our procedures governing the
      processing of incoming investor funds in an effort to strengthen our internal
      control over financial reporting. Our investors periodically wire funds to
      us
      for investment in their investor accounts maintained at the Company, and these
      strengthened procedures apply to those limited cases in which the wiring
      information we receive does not indicate the beneficiary of such funds. For
      these limited cases, the Company has instituted a policy that requires
      full **** verification
      of the source and beneficiary for incoming wire transfers where the beneficiary
      is not immediately recognized. There was no other change in the Company’s
      internal control over financial reporting during the second quarter of 2008
      that
      has materially affected, or is reasonably likely to materially affect, the
      Company’s internal control over financial reporting.





**PART
      II - OTHER INFORMATION**





**Item
      1. Legal Proceedings**





On
      March
      8, 2005, we were notified that a lawsuit had been filed against us (in the
      Circuit Court of Montgomery County, Maryland) by SBM Financial, LLC (“SBM”). SBM
      claims to operate a business similar to ours and that we have intentionally
      interfered with its ability to retain their existing investors. We believe
      that
      this lawsuit has no merit, and we expect it to have no material impact on our
      financial condition or results of operations.





On
      or
      about March 5, 2008, the Maryland Securities Division informed us that it is
      investigating several possible violations of the Maryland Securities Act by
      the
      Company and one of our former Senior Vice Presidents. We are cooperating fully
      with the Maryland Securities Division to resolve this investigation.





First,
      the Maryland Securities Division believes that a former Senior Vice President
      (who resigned in December 2007) offered and sold our investor notes from
      Maryland without being registered as an issuer-agent in Maryland. We anticipate
      that the Maryland Securities Division will require us to enter into a Consent
      Order addressing this alleged violation and impose a civil money penalty against
      us.





18


Second,
      the Maryland Securities Division believes that this former Senior Vice President
      misappropriated approximately $74,872 in checks from an investor between 2004
      and 2006 which she tendered to this Senior Vice President for deposit into
      her
      investor account but which he instead deposited into his personal accounts.
      Upon
      learning of this incident, we restricted the Senior Vice President’s duties and
      handling of any investor funds. We have since instituted policies to reduce
      the
      risk that misappropriations by employees will occur in the future. We have
      set
      aside funds that we believe are sufficient to address the investor’s claim and
      are also pursuing coverage under our policy of fidelity insurance.





Third,
      during the second quarter of 2008, the Maryland Securities Division notified
      us
      that it was investigating whether this former Senior Vice President funded
      his
      mother’s account at the Company using approximately $864,000 that he wrongfully
      obtained from a third party in a personal transaction with that party. We had
      no
      knowledge of any possible wrongdoing with respect to this third party, who
      has
      neither contacted us with respect to these funds nor made a claim to the funds,
      and we are not aware that any wrongdoing has in fact been committed with respect
      to this matter. Further, w e
      believe
      that any liability related to these funds, if any, rests solely with the former
      Senior Vice President. There
      can
      be no guarantee, however, that our beliefs with respect to liability will
      ultimately prove true or that we will not be subjected to litigation regarding
      this matter.





We
      are at
      times, in the ordinary course of business, a party to legal actions normally
      associated with a lending institution.





**Item
      6. Exhibits**





The
      Exhibits filed or furnished with this report are listed in the Exhibit Index
      which immediately follows the signatures to this report, and this Exhibit Index
      is incorporated herein by reference.





**SIGNATURES**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned thereunto
      duly authorized.





KH
                FUNDING COMPANY(Registrant)Dated:
                August 13, 2008
            /s/
                Robert L. HarrisRobert
                L. HarrisPresident,
                Chief Executive Officer, and Acting Chief Financial Officer





19


**EXHIBIT
      INDEX**





Exhibit
            Description31.1
            Certifications
                of the CEO and CFO pursuant to Section 302 of the Sarbanes-Oxley
                Act
                (filed herewith).32.1
            Certification
                of the CEO and CFO pursuant to Section 906 of the Sarbanes-Oxley
                Act
                (furnished herewith).








.


20