**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 March 31, 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 March 31, 2008.









**INDEX**





**Page**Part
                I. Financial Information
            
            3Item
                1. Financial Statements
            
            3Balance
                Sheets -March
                31, 2008 (unaudited) and December 31, 2007
            
            3Statements
                of Operations (unaudited) -For
                the three months ended March 31, 2008 and 2007
            
            4Statements
                of Changes in Stockholders’ Equity (unaudited) -For
                the three months ended March 31, 2008 and 2007
            
            5Statements
                of Cash Flows (unaudited) -For
                the three months ended March 31, 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
            
            17Part
                II. Other Information
            
            17Item
                1. Legal Proceedings
            
            17Item
                6. Exhibits
            
            18Signatures
            
            18Exhibit
                Index
            
            19




-2-




**PART
      I – FINANCIAL INFORMATION**





**Item
      1. Financial Statements.**





**KH
      FUNDING COMPANY**


**BALANCE
      SHEETS**





**March 31,**
              **2008**
            
            **December 31,**
              **2007****(unaudited)**
            
            ******Assets**Cash
            
            $
            88,391
            
            $
            95,622Investments
                available for sale:Nonmarketable
                securities
            
            
            25,437
            
            
            25,437Loans
                receivable, less allowance for loan losses of $525,198 (March 31,2008)
                and
                $495,480 (December 31,2007)
            
            
            45,673,108
            
            
            47,885,188Accrued
                interest receivable
            
            
            1,648,680
            
            
            2,668,649Other
                receivables
            
            
            200,046
            
            
            106,944Prepaid
                expenses
            
            
            157,951
            
            
            208,549Property
                and equipment – Net
            
            
            131,605
            
            
            141,993Real
                estate owned:Rental
                property
            
            
            670,672
            
            
            675,914Held
                for sale
            
            
            2,110,631
            
            
            1,568,655Other
                assets
            
            
            15,988
            
            
            15,988**Total
                Assets**
            
            $
            50,722,509
            
            $
            53,392,939**Liabilities
                and Stockholders’ Equity****Liabilities**Notes
                and accrued interest payable
            
            $
            44,796,753
            
            $
            51,219,963Other
                loans payable
            
            
            857,188
            
            
            702,094Accounts
                payable and accrued expenses
            
            
            33,262
            
            
            32,827Escrows
                and security deposits
            
            
            89,107
            
            
            101,383Long-term
                liabilities
            
            
            39,892
            
            
            35,842Participation
                loans
            
            
            4,258,640
            
            
            261,764**Total
                Liabilities**
            
            
            50,074,842
            
            
            52,353,873**Stockholders’
                Equity**Common
                stock (5,000,000 shares authorized; 2,574,981 shares (March 31,2008)
                and
                2,724,981 shares (December 31,2007) issued and outstanding, $0.01
                par
                value)
            
            
            25,750
            
            
            27,250Paid-in
                capital
            
            
            1,435,935
            
            
            1,730,911Accumulated
                deficit
            
            
            (628,568
            )
            
            (533,645
            )Subscription
                note receivable
            
            
            (185,450
            )
            
            (185,450
            )**Total
                Stockholders’ Equity**
            
            
            647,667
            
            
            1,039,066**Total
                Liabilities and Stockholders’ Equity**
            
            $
            50,722,509
            
            $
            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 March 31,****2008**
            
            **2007****Interest
                Income**Interest
                and fees on loans
            
            $
            1,214,137
            
            $
            1,515,829Interest
                on bank accounts
            
            
            45
            
            
            5,334Interest
                on investments —marketable securities
            
            
            -
            
            
            11,382Total
                interest income
            
            
            1,214,182
            
            
            1,532,545**Interest
                Expense**Interest
                and fees on notes
            
            
            869,777
            
            
            1,006,434Interest
                on other loans
            
            
            91,635
            
            
            77,883Interest
                on participation loans
            
            
            8,068
            
            
            -Total
                interest expense
            
            
            969,480
            
            
            1,084,317Net
                interest income
            
            
            244,702
            
            
            448,228**Provision
                for Loan Losses**
            
            
            79,098
            
            
            45,000**Net
                Interest Income after Provision for Loan Losses**
            
            
            165,604
            
            
            403,228**Non-interest
                Income**Rental
                income
            
            
            22,430
            
            
            14,105Other
            
            
            7,239
            
            
            2,968Total
                non-interest income (loss)
            
            
            29,669
            
            
            17,073**Non-interest
                Expense**Salaries
                and wages
            
            
            86,877
            
            
            113,187Professional
                fees
            
            
            49,959
            
            
            30,477Offering
                costs
            
            
            32,780
            
            
            47,402Administration
            
            
            16,703
            
            
            38,707Real
                estate maintenance
            
            
            21,172
            
            
            24,575Insurance
            
            
            17,105
            
            
            12,567Depreciation
            
            
            15,630
            
            
            14,045Rent
            
            
            29,819
            
            
            29,005Bank
                charges
            
            
            13,755
            
            
            8,640Stock
                based compensation
            
            
            3,523
            
            
            7,500Other
            
            
            2,873
            
            
            9,832Total
                non-interest expense
            
            
            290,196
            
            
            335,937**Net
                (Loss) Income**
            
            $
            (94,923
            )
            $
            84,364Basic
                earnings per share
            
            $
            (0.04
            )
            $
            0.03Diluted
                earnings per share
            
            
            (0.04
            )
            
            0.03Cash
                dividends paid per common share
            
            
            -
            
            
            0.02





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




-4-




**KH
      FUNDING COMPANY**


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


**FOR
      THE THREE MONTHS ENDED MARCH 31, 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**
            
            
            
            
            
            
            
            
            
            
            
            –
            
            
            –
            
            
            –**Dividends
                Declared**
            
            
            
            
            
            
            
            
            (54,538
            )
            
            
            
            
            
            
            
            
            
            
            (54,538
            )**Stock
                Based Compensation Expense**
            
            
            –
            
            
            –
            
            
            7,500
            
            
            –
            
            
            –
            
            
            –
            
            
            7,500**Comprehensive
                income**Net
                income for period ended March 31, 2007
            
            
            –
            
            
            –
            
            
            –
            
            
            84,364
            
            
            –
            
            
            –
            
            
            84,364Change
                in fair value of investments
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            10,475
            
            
            10,475**Total
                Comprehensive Income for the Period**
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            –
            
            
            94,839**Balances
                at March 31, 2007**
            
            
            2,726,951
            
            $
            27,269
            
            $
            1,832,745
            
            $
            (184,756
            )
            $
            (185,450
            )
            $
            (23,693
            )
            $
            1,466,115**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**
            
            
            
            
            
            
            
            
            3,523
            
            
            
            
            
            
            
            
            
            
            
            3,523Net
                loss for period ended March 31, 2008
            
            
            –
            
            
            –
            
            
            –
            
            
            (94,923
            )
            
            –
            
            
            –
            
            
            (94,923
            )******Balances
                at March 31, 2008**
            
            
            2,574,981
            
            $
            25,750
            
            $
            1,435,934
            
            $
            (628,568
            )
            $
            (185,450
            )
            
            
            
            $
            $647,666





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




-5-




**KH
      FUNDING COMPANY**


**STATEMENTS
      OF CASH FLOWS (UNAUDITED)**





**For the three months ended March 31,****2008**
            
            **2007****Cash
                from Operating Activities**Net
                (loss) income
            
            $
            (94,923
            )
            $
            84,364**Adjustments
                to Reconcile Net Income to Net Cash from Operating
                Activities:**Depreciation
            
            
            15,630
            
            
            14,045Amortization
                of loan fees
            
            
            (7,500
            )
            
            (27,000
            )Provision
                for loan losses
            
            
            79,098
            
            
            45,000Stock
                based compensation expense
            
            
            3,524
            
            
            7,500**Changes
                in Operating Assets and Liabilities**Accrued
                late charges
            
            
            (6,677
            )
            
            (2,954
            )Prepaid
                expenses
            
            
            32,554
            
            
            (8,811
            )Interest
                receivable
            
            
            1,019,969
            
            
            (165,760
            )Interest
                payable (included in notes payable)
            
            
            563,072
            
            
            670,409Accounts
                payable and accrued expenses
            
            
            435
            
            
            3,654Accrued
                interest on investments
            
            
            -
            
            
            (9,000
            )Prepaid
                offering costs
            
            
            18,045
            
            
            26,420Deferred
                loan origination costs
            
            
            3,450
            
            
            3,000Unamortized
                brokerage fees
            
            
            15,500
            
            
            7,784Long
                term lease liability
            
            
            4,050
            
            
            3,777Prepaid
                loan expenses
            
            
            25,797
            
            
            2,053**Net
                Cash Provided by Operating Activities**
            
            
            1,672,024
            
            
            654,481******Cash
                Flows from Investing Activities**Principal
                repayments from borrowers
            
            
            5,841,137
            
            
            2,571,917Loans
                made to borrowers
            
            
            (4,265,201
            )
            
            (4,469,384
            )Proceeds
                from sale of marketable securities and other investments
            
            
            -
            
            
            (2,382
            )(Payments)
                collections for other receivables
            
            
            (93,102
            )
            
            576,422Purchase
                of property and equipment
            
            
            -
            
            
            (7,044
            )Payments
                on real estate owned
            
            
            -
            
            
            (500
            )**Net
                Cash Provided by (Used in) Investing Activities**
            
            
            1,482,834
            
            
            (1,330,971
            )**Cash
                Flows from Financing Activities**Proceeds
                from investor notes
            
            
            851,270
            
            
            898,276Proceeds
                from other loans
            
            
            155,094
            
            
            7,714,066Principal
                payments on investor notes
            
            
            (7,853,052
            )
            
            (10,081,768
            )Increase
                in participation loans
            
            
            3,996,875
            
            
            -Increase
                (decrease) in unapplied deposits
            
            
            -
            
            
            30,250Redemption
                of common stock
            
            
            (300,000
            )
            
            -Payment
                of dividends
            
            
            -
            
            
            (54,538
            )Decrease
                in escrow and security deposits
            
            
            (12,276
            )
            
            (27,395
            )**Net
                Cash Used in Financing Activities**
            
            
            (3,162,089
            )
            
            (1,521,109
            )**Net
                Decrease in Cash**
            
            
            (7,231
            )
            
            (2,197,599
            )**Cash
                Balance,** beginning of period
            
            
            95,622
            
            
            3,823,013**Cash
                Balance,**end of period
            
            $
            88,391
            
            $
            1,625,414**Supplemental
                Cash Flow Information:**Interest
                paid
            
            $
            406,407
            
            $
            413,908Transfer
                of loans to real estate owned
            
            $
            541,976
            
            $
            306,922




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




-6-




KH
      Funding Company


Notes
      to
      Interim Financial Statements


For
      the
      Three Months Ended March 31, 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 March 31,
      2008, the results of operations for the three-month periods ended March 31,
      2008
      and 2007, changes in stockholders’ equity for the three-month periods ended
      March 31, 2008 and 2007, and cash flows for the three-month periods ended March
      31, 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-month period
      ended
      March 31, 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. On
      May
      5, 2008, the Company filed a new amendment to its registration statement with
      the SEC and several state securities regulators covering the offer and sale
      of
      investor notes, but 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 loans in the future will exceed the
      amounts needed to fund redemption requests and pay other operational expenses.
      Additionally, stockholders’ equity at March 31, 2008 has decreased to 1.3% 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 of
      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 nationwide from
      other lenders and banks. 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 March 31, 2008 and March 31, 2007, the
      Company had outstanding stock options to purchase 241,250 and 411,250 shares
      of
      common stock, respectively. For the three months ended March 31, 2008 and 2007,
      options to purchase 241,250, 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**
              **March 31,****2008**
            
            **2007****(unaudited)**Basic:Net
                (loss) income (attributable to common stock)
            
            $
            (94,923
            )
            $
            84,364Weighted
                average common shares outstanding
            
            
            2,574,981
            
            
            2,726,951Basic
                earnings per share
            
            $
            (0.04
            )
            $
            0.03Diluted:Net
                (loss) income (attributable to common stock)
            
            $
            (94,923
            )
            $
            84,364Weighted
                average common shares outstanding
            
            
            2,574,981
            
            
            2,726,951Dilutive
                effect of stock options
            
            
            -
            
            
            98,750Weighted
                average common shares outstanding-diluted
            
            
            2,574,981
            
            
            2,828,701Diluted
                earnings per share
            
            $
            (0.04
            )
            $
            0.03





**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:





**March 31,**
              **2008**
            
            **December 31,**
              **2007****(unaudited)**Total
                recorded investment in impaired loans
            
            $
            3,329,468
            
            $
            510,697Amount
                of that recorded investment for which there is a related allowance
                for
                loan losses
            
            $
            3,329,468
            
            $
            510,697Amount
                of related allowance for loan losses associated with such
                investment
            
            $
            354,599
            
            $
            306,815Amount
                of that recorded investment for which there is no related allowance
                for
                loan losses
            
            $
            -
            
            $





**For the three months**
              **ended March 31,**
              **2008**
            
            **For the year ended**
              **December 31,**
              **2007****(unaudited)**Average
                recorded investment in impaired loans during period
            
            $
            1,920,083
            
            $
            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
      March
      31, 2008 and December 31, 2007, the Company had loans of $4,783,832 and
      $1,634,947, 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 three months**
              **ended March 31,**
              **2008**
            
            **For the three months**
              **ended March 31,**
              **2007****(unaudited)**
            
            **(unaudited)**Beginning
                balance
            
            $
            495,480
            
            $
            452,154Provision
                for loan losses
            
            
            79,098
            
            
            45,000Loans
                charged off
            
            
            (49,380
            )
            
            (152,638
            )Ending
                Balance
            
            $
            525,198
            
            $
            344,516





**NOTE
      D—INVESTMENTS**





Other
      investments available for sale of $25,437 at March 31, 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 March 31, 2008 and December 31, 2007, are 10 notes
      totaling $10,435,468 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 (93.6%) of these notes receivable were due from one stockholder
      and
      its related interests, who owed $9,767,866 as of March 31, 2008.





Included
      in the notes payable and other loans payable balances at March 31, 2008 and
      December 31, 2007, are 64 notes totaling $7,318,707 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 was issued.





During
      the three months ended March 31, 2008, the Company had short-term net borrowings
      of $155,093 from five stockholders and holders of investment notes. These
      borrowings are included with Other Loans Payable on the balance sheet. These
      loans are due and payable upon demand.




-10-




There
      is
      a note receivable of $185,450 included in other receivables, shown on the
      balance sheet at March 31, 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
      March 31, 2008 and December 31, 2007, all payments under this loan had been
      timely made and the there was no accrued interest receivable on this
      loan.





Included
      in the notes receivable at March 31, 2008 are six loans in the amount of
      $9,767,866 to a trust for the benefit of a significant stockholder. The majority
      of these loans ($9.54 million) were made prior to the period ending March 31,
      2008. 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 the 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
      quarters ended March 31, 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.





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 three months ended March 31, 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 three months ended March 31, 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 $3,523 and $7,500 stock-based compensation expense during
      the
      three months ended March 31, 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 $7,500,
      respectively, for the three months ended March 31, 2008 and 2007.





A
      summary
      of stock option activity during the three months ended March 31, 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 March 31, 2008
            
            
            241,250
            
            
            2.39
            
            
            2.09
            
            
            -Exercisable
                at March 31, 2008
            
            
            187,917
            
            
            2.17
            
            
            1.75
            
            
            -




-11-




**NOTE
      G—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 March 31, 2008, the Company had $5.67 million in loans of this type.
      The unused or unfunded amount on these types of loans totaled $.90 million
      as of
      March 31, 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. 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**





On
      May 5,
      2008, we filed a post-effective amendment to our most recent registration
      statement covering our investor notes with the SEC and several state securities
      regulators to renew our investor note sales efforts. 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 United States
      Securities and Exchange Commission (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. Both the SEC and the Maryland
      Securities Division have decided to review the amended registration statement,
      and the Maryland Securities Division has issued comments and requested
      revisions. The SEC may also issue comments and request revisions.





As
      discussed in our Annual Report on Form 10-KSB for the year ended December 31,
      2007, the Division
      of Securities of the Office of the Maryland Attorney General (the “Maryland
      Securities Division”) is currently investigating the actions of a former
      employee who allegedly misappropriated funds from an investor between 2004
      and
      2006. We have worked diligently with the Maryland Securities Division to address
      this matter and offered the investor full restitution in April 2008. The
      Maryland Securities Division also believes that this former employee may have
      offered and sold securities without being registered as an issuer-agent. We
      anticipate that the Maryland Securities Division will require us to enter into
      a
      Consent Order regarding this alleged violation of the issuer-agent registration
      requirement, and it may also impose a money penalty against us.





The
      aforementioned review by the SEC and the Maryland Securities Division and
      investigation may delay the effectiveness of our amended registration statement
      and, thus, our ability to sell our investor notes.





**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. To
      fund
      our operations, we rely on interest income generated from our lending and
      investment activities and from proceeds from sales of interest bearing debt
      securities, or investor notes, to investors, such as the Notes.




-12-




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.





In
      prior
      periods, we used funds obtained from loan repayments and offerings of our
      investor notes to originate most of the loans in our portfolio. However, rather
      than directly originating new loans, in the last six years we have increasingly
      engaged in the wholesale purchase of loans for our loan portfolio and are now
      purchasing approximately 80% of our new loans. We intend to continue to expand
      this wholesale component of our operations and expect it to continue to be
      a
      major part of our loan acquisition strategy. 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.




Our
      business strategy is to grow and enhance our profitability by increasing our
      portfolio of mortgage and business loans. We anticipate that the funds necessary
      to carry through with this strategy will come from our lending activities and
      proceeds of sales of our investor notes, such as the Notes. In addition, we
      may
      seek to raise funds through private sales of our capital stock.





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 NASD registered broker-dealers 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 NASD member 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, because of delays in registering our offerings
      of
      such notes. 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 registration statement
      will be declared 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
      March 31, 2008 our sub-prime loans amounted to only $3.15 million, or 6.89%
      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.
      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. 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.




-13-




**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 March 31, 2008 and December 31,
      2007**





*Assets* .
      Total
      assets decreased by $2,670,430, from $53,392,939 at December 31, 2007 to
      $50,722,509 at March 31, 2008. The size of our loan portfolio decreased
      $2,212,080 ending at $45,673,108. 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 $2,279,032, from  $52,353,874
      at December 31, 2007 to $50,074,842 at March 31, 2008. The net decrease was
      primarily due to $7,853,052 in investor note redemptions, offset by an increase
      of $3,996,875 in loan participations sold.





*Equity* .
      Total
      stockholders’ equity decreased by $391,400 from $1,039,066 at December 31, 2007
      to $647,667 at March 31, 2008. The decrease was due to a net loss of $94,923
      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 $3,523 and the repurchase of 150,000 shares of stock at $2.00
      per share.





*Past
      Due Loans* .
      As of
      March 31, 2008, we held 17 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 $4,783,832, compared to $5,002,259 as of
      December 31, 2007. Five of the loans, totaling $967,528, 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 12 loans, totaling
      $3,816,304, 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
      March 31, 2008, there were 19 loans in non-accrual status with an outstanding
      principal balance totaling $2,830,781, 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 March 31, 2008, we had a specific reserve
      of
      $354,599 and a general reserve of $170,599 as part of our total reserve of
      $525,198 for anticipated and unanticipated loan losses.





**Comparison
      of Operating Results for Three Months Ended March 31, 2008 and
      2007**





*Net
      interest margin.* The
      average yield earned on loans receivable was 10.32% for the three months ended
      March 31, 2008 and 10.45% for the three months ended March 31, 2007. The average
      rate paid on investor notes increased to 6.91% for the three months ended March
      31, 2008 from 6.79% for the three months ended March 31, 2007, due primarily
      to
      an increase 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 3.41% for the three months ended March 31, 2008, from 3.66% for
      the
      three months ended March 31, 2007. This net margin is calculated using
      contractual rates and excludes fee income and expense.




-14-




*Net
      Income/Loss* .
      Net
      loss for the three months ended March 31, 2008 was $94,923, compared to net
      income of $84,364 for the three months ended March 31, 2007. The difference
      resulted primarily 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 $1,214,182 for the three months ended March 31, 2008,
      compared to $1,532,545 for the same period in 2007. The decrease in interest
      income was due primarily to a decrease of $312,192 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 $969,480 for the three months ended March 31, 2008, and
      $1,084,317 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 $79,098 for the three months ended March 31,
      2008,
      compared to $45,000 for the three months ended March 31, 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 $29,669 during the three months ended March 31, 2008,
      compared to $17,073 for the corresponding period in 2007. The difference was
      due
      to an increase of $8,325 from rental income earned on other real estate owned.





*Non-Interest
      Expense* .
      Non-interest expense decreased to $290,196 for the three months ended March
      31,
      2008 from $335,937 for the three months ended March 31, 2007. The decrease
      was
      due to a reduction in salaries and wages, securities offering costs and
      administration 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.





**Liquidity
      and Capital Resources**





For
      the
      three months ended March 31, 2008, net cash provided by operating activities
      was
      $1,672,024, compared to $654,481 for the quarter ended March 31, 2007. The
      primary reasons for the increase were a $1,019,969 reduction in
      interest receivable on loans as a result of loan payoffs during the period
      and
      an increase of $563,072 in interest payable on notes payable during the period.





For
      the
      three months ended March 31, 2008, net cash provided by investing activities
      was
      $1,482,834, compared to net cash used in investing activities of $1,330,971
      for
      the same period in 2007. Cash provided by investing activities for the first
      quarter of 2008 included $5,841,137 in principal repayments on loans receivable
      offset by $4,265,201 in loans made to borrowers, compared to $2,571,917 and
      $4,469,384, respectively, for the first quarter of 2007.





For
      the
      three months ended March 31, 2008, net cash used in financing activities was
      $3,162,089, compared to $1,521,109 for the same period in 2007. Net proceeds
      from loan participations sold of $3,996,875 and reinvestments by holders of
      our
      investor notes of $851,270 were offset by $7,853,052 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.




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During
      the first quarter of 2008, we received approximately $6,861,106 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 first quarter of 2008, however, we have been unable to sell our investor
      notes due to delays in obtaining an effective registration in the State of
      Maryland. Although we renewed our offering efforts on May 5, 2008 by filing
      an
      amended registration statement covering investor notes with the SEC and several
      states, including Maryland, this registration statement has not yet been
      declared effective. Although we anticipate that our registration statement
      will
      be declared effective during the second quarter of 2008, 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.





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 30 days’ prior notice. Holders of thirty
      day demand notes can make redemption requests by giving us 90 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 3% to 7%
      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 March
      31,
      2008, however, we had cash and cash equivalents of $88,391, or 0.17% of total
      assets, a historically low level, compared to $95,622 at December 31, 2007
      and
      $1,625,414 at March 31, 2007. 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 March 31, 2008, we
      held approximately $10,013,363 million in mortgage loans that we believe could
      be sold within a short period of time. 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. As a result of these
      legal and market factors, we may not be able to sell loans from our portfolio
      in
      order 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
      March
      31, 2008, cash and cash equivalents were $88,391, compared to outstanding one
      day demand notes of $6,908,137 million and outstanding thirty day demand notes
      of $9,471,188 million. The maturities of our outstanding investor notes at
      March
      31, 2008 are as follows:




**Balance****Series
                3 Demand Notes**One
                Day
            
            $
            6,797,166Thirty
                Day
            
            $
            9,564,774**Series
                3 Fixed Term Notes:**Due
                within 1 year
            
            $
            8,476,709Due
                in 1 to 3 years
            
            $
            6,081,740Due
                in 3 to 5 years
            
            $
            7,068,427**Series
                4 Fixed Term Notes:**Due
                within 1 year
            
            $
            2,075,447Due
                in 1 to 3 years
            
            $
            342,579Due
                in 3 to 5 years
            
            $
            4,505,945Subtotal
            
            $
            44,912,787Unamortized
                brokerage costs
            
            
            (116,033
            )Total
                investor notes, net
            
            $
            44,796,754





The
      Company has never failed to satisfy a redemption requests 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.




-16-




**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 1.3% at March 31, 2008. During
      the period ending March 31, 2008, we experienced an operating loss of $94,923
      combined with stock repurchases of $300,000 resulting in an ending balance
      in
      stockholders equity of $647,667. 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 (“CEO”), 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, control 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 March 31,
      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 first quarter of 2008, to address the material weaknesses identified in
      our
      Annual Report on Form 10-KSB for the year ended December 31, 2007, we made
      the
      following changes in our internal control over financial reporting that have
      materially affected, or are reasonably likely to materially affect, our internal
      control over financial reporting:





·
            We
                began to take steps to correct the previously disclosed lack of tangible
                audit trails (such as documentation, dates, and signatures) of the
                performance of control activities, including better review of journal
                entries, reconciliation of accounts, and valuation of collateral
                and
                properties.





·
            We
                began reviewing our loan and investor files to determine whether
                they are
                complete and, where incomplete, obtaining any missing information.





·
            Mr.
                Harris resigned as member of the Audit Committee effective January
                16,
                2008.





**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
      the SEC has requested that a receiver be appointed to liquidate the assets
      of
      SBM. 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.




-17-




On
      or
      about March 5, 2008, the Maryland Securities Division informed us that it was
      investigating the possible offer and sale of our investor notes from and to
      Maryland by a former employee who was not 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 may impose
      a
      civil money penalty against us.




**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:
                May 15, 2008
            /s/
                Robert L. HarrisRobert
                L. HarrisPresident,
                Chief Executive Officer, and Acting Chief
              Financial
                Officer




-18-




**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).




-19-