**FORM
      10-QSB**





**U.S.
      SECURITIES AND EXCHANGE COMMISSION**


**WASHINGTON,
      D.C. 20549**





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





**For
      the quart** **erly
      period ended September 30, 2007**





**Commission
      File Number 333-124155**








**KH
      FUNDING COMPANY**


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








**Maryland**
            **6162**
            **52-1886133****(State
                or other jurisdiction of**
              **incorporation
                or organization)**
            **(Primary
                Standard Industrial**
              **Classification
                Code Number)**
            **(I.R.S.
                Employer**
              **Identification
                No.)**





**10801
      Lockwood Drive, Suite 370**


**Silver
      Spring, Maryland 20901**


**(301)
      592-8100**


**(address
      and telephone number of principal executive office)**










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




Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      126-2 of the Exchange Act). YES o NO x




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





**Class**
            
            **Outstanding
                as of September 30, 2007**Common
                Stock, $0.01 par value per share
            
            2,724,981




Transitional
      Small Business Disclosure Format (Check One): YES  ̈ NO x


















**PART
      I** **- FINANCIAL INFORMATION**


**ITEM
                1.****FINANCIAL
                STATEMENTS**
            **PAGE
                NOS.**BALANCE
                SHEETS - September 30, 2007 (UNAUDITED) and December 31,
                2006
            3STATEMENTS
                OF OPERATIONS (UNAUDITED), for the three and nine months ended September
                30, 2007 and 2006
            4STATEMENTS
                OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED), for the nine months ended
                September 30, 2007 and 2006
            5STATEMENTS
                OF CASH FLOWS (UNAUDITED), for the nine months ended September 30,
                2007
                and 2006
            6NOTES
                TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)
            7-12










-2-


**KH
      FUNDING COMPANY**


**BALANCE
      SHEETS**





**September
                30,**
              **2007**
            
            **December
                31,**
              **2006****(unaudited)**
            
            ******Assets**Cash
            
            $
            165,723
            
            $
            3,823,013Investments
                available for sale:Marketable
                securities - at fair value
            
            
            -
            
            
            581,149Other
            
            
            50,872
            
            
            50,872Loans,
                less allowance for loan losses of $414,354(2007)
                and $452,154 (2006)
            
            
            50,196,902
            
            
            54,704,020Accrued
                interest receivable
            
            
            2,348,057
            
            
            1,961,683Other
                receivables
            
            
            807,845
            
            
            611,397Prepaid
                expenses
            
            
            240,065
            
            
            294,496Property
                and equipment - Net
            
            
            154,946
            
            
            143,419Real
                estate owned:Rental
                property
            
            
            743,541
            
            
            814,441Held
                for sale
            
            
            1,745,223
            
            
            325,223Other
                assets
            
            
            15,988
            
            
            15,988**Total
                Assets**
            
            $
            56,469,162
            
            $
            63,325,701**Liabilities
                and Stockholders' Equity****Liabilities**Notes
                and accrued interest payable
            
            $
            48,272,900
            
            $
            61,774,343Other
                loans payable
            
            
            6,684,548
            
            
            -Accounts
                payable and accrued expenses
            
            
            32,874
            
            
            21,980Escrows
                and security deposits
            
            
            96,089
            
            
            111,064**Total
                Liabilities**
            
            
            55,086,411
            
            
            61,907,387**Stockholders'
                Equity**Common
                stock (5,000,000 shares authorized; 2,724,981 shares (2007) and 2,726,951
                shares (2006) issued and outstanding, $0.01 par value)
            
            
            27,250
            
            
            27,269Paid-in
                capital
            
            
            1,727,534
            
            
            1,879,783Accumulated
                deficit
            
            
            (186,583
            )
            
            (269,120
            )Subscription
                note receivable
            
            
            (185,450
            )
            
            (185,450
            )Accumulated
                other comprehensive loss
            
            
            -
            
            
            (34,168
            )**Total
                Stockholders' Equity**
            
            
            1,382,751
            
            
            1,418,314**Total
                Liabilities and Stockholders' Equity**
            
            $
            56,469,162
            
            $
            63,325,701





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


-3-


**KH
      FUNDING COMPANY**


**STATEMENTS
      OF OPERATIONS (UNAUDITED)**




**For
                the Three**
              **Months**
              **Ended
                September 30,**
            
            **For
                the Nine**
              **Months**
              **Ended
                September 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006****Interest
                Income**Interest
                and fees on loans
            
            $
            1,489,711
            
            $
            1,616,788
            
            $
            4,537,769
            
            $
            4,295,628Interest
                on bank accounts
            
            
            48
            
            
            15,281
            
            
            5,759
            
            
            112,233Interest
                on investments —marketable securities
            
            
            6,539
            
            
            6,996
            
            
            25,267
            
            
            22,461Total
                interest income
            
            
            1,496,298
            
            
            1,639,065
            
            
            4,568,795
            
            
            4,430,322**Interest
                Expense**Interest
                and fees on Notes
            
            
            991,827
            
            
            1,078,502
            
            
            2,945,585
            
            
            2,910,264Interest
                on other loans
            
            
            124,500
            
            
            -
            
            
            325,000
            
            
            -Total
                interest expense
            
            
            1,116,327
            
            
            1,078,502
            
            
            3,270,585
            
            
            2,910,264Net
                interest income
            
            
            379,971
            
            
            560,563
            
            
            1,298,210
            
            
            1,520,058**Provision
                for Loan Losses**
            
            
            75,000
            
            
            55,832
            
            
            195,000
            
            
            175,103**Net
                Interest Income after Provision for Loan Losses**
            
            
            304,971
            
            
            504,731
            
            
            1,103,210
            
            
            1,344,955**Non-interest
                Income (loss)**Rental
                income
            
            
            16,536
            
            
            13,628
            
            
            46,057
            
            
            38,387Loss
                on sale of real estate
            
            
            (8,864
            )
            
            (130,795
            )
            
            (20,736
            )
            
            (156,482
            )Loss
                on sale of securities
            
            
            (52,567
            )
            
            -
            
            
            (52,567
            )
            
            -Other
            
            
            2,742
            
            
            8,133
            
            
            8,446
            
            
            16,837Total
                non-interest income (loss)
            
            
            (42,153
            )
            
            (109,034
            )
            
            (18,800
            )
            
            (101,258
            )**Non-interest
                Expense**Salaries
                and wages
            
            
            127,827
            
            
            119,027
            
            
            374,179
            
            
            328,407Professional
                fees
            
            
            71,726
            
            
            51,664
            
            
            136,106
            
            
            135,343Offering
                costs
            
            
            40,663
            
            
            54,663
            
            
            124,065
            
            
            168,488Administration
            
            
            16,001
            
            
            19,583
            
            
            58,521
            
            
            85,626Real
                estate maintenance
            
            
            19,238
            
            
            36,704
            
            
            77,286
            
            
            82,496Insurance
            
            
            22,947
            
            
            18,282
            
            
            51,577
            
            
            56,573Depreciation
            
            
            14,746
            
            
            14,609
            
            
            43,573
            
            
            43,745Rent
            
            
            28,428
            
            
            29,171
            
            
            86,401
            
            
            89,665Bank
                charges
            
            
            13,788
            
            
            13,591
            
            
            34,411
            
            
            25,275Other
            
            
            2,047
            
            
            3,178
            
            
            15,754
            
            
            22,624Total
                non-interest expense
            
            
            357,411
            
            
            360,472
            
            
            1,001,873
            
            
            1,038,242**Net
                Income (Loss)**
            
            $
            (94,593
            )
            $
            35,225
            
            $
            82,537
            
            $
            205,455Basic
                earnings per share
            
            $
            (0.03
            )
            $
            0.01
            
            $
            0.03
            
            $
            0.08Diluted
                earnings per share
            
            
            (0.03
            )
            
            0.01
            
            
            0.03
            
            
            0.08Cash
                dividends paid per common share
            
            
            0.02
            
            
            0.02
            
            
            0.06
            
            
            0.06





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


-4-


**KH
      FUNDING COMPANY**


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


**FOR
      THE NINE MONTHS ENDED SEPTEMBER 30, 2007 and 2006**





**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**Stock
                Redemptions**
            
            
            (2,300
            )
            
            
            (23
            )
            
            
            (4,577
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (4,600
            )**Stock
                Based Compensation Expense**
            
            
            -
            
            
            
            -
            
            
            
            15,500
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            15,500**Dividends
                Paid $0.06 per share**
            
            
            -
            
            
            
            -
            
            
            
            (164,028
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (164,028
            )**Comprehensive
                income**Net
                income for period ended September 30, 2007
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            82,537
            
            
            
            -
            
            
            
            -
            
            
            
            82,537Change
                in fair value of investments
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            34,168
            
            
            
            34,168**Total
                Comprehensive Income for the Period**
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            116,705**Balances
                at September 30, 2007**
            
            
            2,724,981
            
            
            $
            27,250
            
            
            $
            1,727,534
            
            
            $
            (186,583
            )
            
            $
            (185,450
            )
            
            $
            -
            
            
            $
            1,382,751**Balances
                at January 1, 2006**
            
            
            2,555,556
            
            
            $
            25,556
            
            
            $
            1,603,852
            
            
            $
            (429,688
            )
            
            $
            (185,450
            )
            
            $
            (99,463
            )
            
            $
            914,807**Additional
                Stock Issued**
            
            
            174,395
            
            
            
            1,743
            
            
            
            451,741
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            453,484**Stock
                Based Compensation Expense**
            
            
            
            
            
            
            
            
            
            
            36,700
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            36,700**Dividends
                Paid $0.06 per share**
            
            
            
            
            
            
            
            
            
            
            (159,741
            )
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            (159,741
            )**Comprehensive
                income**Net
                income for period ended September 30, 2006
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            205,455
            
            
            
            -
            
            
            
            -
            
            
            
            205,455Change
                in fair value of investments
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            51,117
            
            
            
            51,117**Total
                Comprehensive Income for the Period**
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            256,572**Balances
                at September 30, 2006**
            
            
            2,729,951
            
            
            $
            27,299
            
            
            $
            1,932,552
            
            
            $
            (224,233
            )
            
            $
            (185,450
            )
            
            $
            (48,346
            )
            
            $
            1,501,822





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


-5-


**KH
      FUNDING COMPANY**


**STATEMENTS
      OF CASH FLOWS (UNAUDITED)**





**For
                the nine months ended September 30,****2007**
            
            **2006****Cash
                from Operating Activities**Net
                income
            
            $
            82,537
            
            $
            205,455**Adjustments
                to reconcile net income to net cash from operating
                activities:**Depreciation
            
            
            43,573
            
            
            43,745Amortization
                of loan fees
            
            
            (87,000
            )
            
            (126,000
            )Provision
                for loan losses
            
            
            195,000
            
            
            175,103Loss
                on sale of real estate owned
            
            
            20,736
            
            
            156,482Stock-based
                compensation expense
            
            
            15,500
            
            
            36,700Loss
                on sale of securities
            
            
            52,567**Changes
                in Operating Assets and Liabilities:**Interest
                receivable
            
            
            (386,374
            )
            
            (529,893
            )Prepaid
                offering costs
            
            
            167,724
            
            
            227,636Prepaid
                expenses
            
            
            (113,293
            )
            
            (203,060
            )Unamortized
                brokerage fees
            
            
            13,470
            
            
            (50,743
            )Deferred
                loan origination costs
            
            
            7,680
            
            
            (14,708
            )Accounts
                payable and accrued expenses
            
            
            10,894
            
            
            (1,805
            )Accrued
                late charges
            
            
            (7,406
            )
            
            (14,989
            )Increase
                in prepaid loan expenses
            
            
            51,941
            
            
            -Interest
                payable (included in notes payable)
            
            
            1,644,812
            
            
            1,573,154**Net
                Cash Provided by Operating Activities:**
            
            
            1,712,361
            
            
            1,291,299**Cash
                Flows from Investing Activities**Principal
                repayments from borrowers
            
            
            13,489,339
            
            
            21,286,337Loans
                made to borrowers
            
            
            (10,999,358
            )
            
            (27,433,890
            )Loans
                purchased
            
            
            -
            
            
            (7,364,900
            )Proceeds
                from sale of marketable securities and other investments
            
            
            562,750
            
            
            71,761Collections
                (payments) for other receivables
            
            
            (164,086
            )
            
            (291,420
            )Proceeds
                from sale of other real estate owned
            
            
            478,473
            
            
            -Purchase
                of property and equipment
            
            
            (41,887
            )
            
            (15,370
            )Payments
                on other real estate owned
            
            
            4,600
            
            
            (488,449
            )**Net
                Cash Provided by (Used in) Investing Activities**
            
            
            3,320,631
            
            
            (14,072,754
            )**Cash
                Flows from Financing Activities**Proceeds
                from investor notes
            
            
            2,248,012
            
            
            87,950,172Proceeds
                from other loans
            
            
            6,684,548
            
            
            309,982Principal
                payments on investor notes
            
            
            (17,407,737
            )
            
            (77,044,124
            )Proceeds
                from sales of common stock
            
            
            860
            
            
            483,184Payments
                on redemption of common stock
            
            
            (4,600
            )
            
            -Payment
                of dividends
            
            
            (164,028
            )
            
            (159,741
            )(Decrease)
                Increase in escrow and security deposits
            
            
            (47,337
            )
            
            (72,628
            )**Net
                Cash (Used in) Provided by Financing Activities**
            
            
            (8,690,282
            )
            
            11,466,845**Net
                Decrease in Cash**
            
            
            (3,657,290
            )
            
            (1,314,610
            )**Cash
                Balance,**beginning of period
            
            
            3,823,013
            
            
            6,579,242**Cash
                Balance,**end
                of period
            
            $
            165,723
            
            $
            5,264,632**Supplemental
                Cash Flow Information:**Interest
                paid
            
            $
            1,625,773
            
            $
            1,337,110Transfer
                of loans to other real estate owned
            
            $
            1,856,922
            
            $
            332,137





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


-6-
 **KH
            FUNDING COMPANY**
 
 **NOTES
            TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)**
 **FOR
            THE THREE AND** **NINE
            MONTHS ENDED SEPTEMBER 30, 2007 and 2006**






**NOTE
      A—BASIS OF PRESENTATION**




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.




The
      financial statements of KH Funding for the three and nine month periods ended
      September 30, 2007 and 2006 are unaudited and include all adjustments which,
      in
      the opinion of management, are necessary to present fairly the financial
      condition and results of operations as of and for the periods then ended. All
      such adjustments are of a normal and recurring nature.




The
      accompanying unaudited financial statements have been prepared in conformity
      with generally accepted accounting principles in the United States ("GAAP")
      for
      interim financial information, as well as in accordance with the instructions
      to
      Form 10-QSB. Accordingly, the information and footnotes required by GAAP for
      non-interim, or complete financial statements are not included. Operating
      results for the interim periods reflected do not necessarily indicate the
      results that may be expected for a full fiscal year. These financial statements
      should be read in conjunction with the financial statements contained in the
      Company's Form 10-KSB for the year ended December 31, 2006 filed with the
      Securities and Exchange Commission on April 6, 2007.




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




**Significant Accounting
      Policies and Estimates**




Note
      A of
      the Notes to Financial Statements in our Annual Report on Form 10-KSB for the
      year ended December 31, 2006 describes the significant accounting policies
      used
      in the preparation of the Company’s financial statements.




**Nature
      of Operations**




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 first and second trust residential 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 accounting principles
      generally accepted in the United States of America, 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 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 September 30, 2007 and September 30, 2006
      the Company had 341,250 and 471,250 options outstanding, respectively. For
      the
      nine months ended September 30, 2007 and 2006, 150,000, and 0 options,
      respectively, were excluded from the computation of dilutive earnings per share
      as their effect would have been anti-dilutive.




-7-
 **KH
            FUNDING COMPANY**
 
 **NOTES
            TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)**
 **FOR
            THE THREE AND** **NINE
            MONTHS ENDED SEPTEMBER 30, 2007 and 2006**






**For
                The Three**
              **Months
                Ended**
              **September
                30,**
            
            **For
                The Nine**
              **Months
                Ended**
              **September
                30,****2007**
            
            **2006**
            
            **2007**
            
            **2006****(unaudited)**
            
            **(unaudited)**Basic:Net
                (loss) income (attributable to common stock)
            
            $
            (74,342
            )
            $
            35,225
            
            $
            82,537
            
            $
            205,455Weighted
                average common shares outstanding
            
            
            2,725,331
            
            
            2,729,951
            
            
            2,726,485
            
            
            2,669,276Basic
                earnings per share
            
            $
            (0.03
            )
            $
            0.01
            
            $
            0.03
            
            $
            0.08Diluted:Net
                income (attributable to common stock)
            
            $
            (74,342
            )
            $
            35,225
            
            $
            82,537
            
            $
            205,455Weighted
                average common shares outstanding
            
            
            2,725,331
            
            
            2,729,951
            
            
            2,726,485
            
            
            2,669,276Dilutive
                effect of stock options
            
            
            240,952
            
            
            98,750
            
            
            230,000
            
            
            91,865Weighted
                average common shares outstanding-diluted
            
            
            2,966,283
            
            
            2,828,701
            
            
            2,956,485
            
            
            2,761,141Diluted
                earnings per share
            
            $
            (0.03
            )
            $
            0.01
            
            $
            0.03
            
            $
            0.07





**Income
      Taxes**





The
      Company has elected under the Internal Revenue Code to be treated as an “S
      Corporation.” As such the corporate income is taxed to individual shareholders
      based upon their proportionate share of the Company’s taxable income. Therefore,
      no provision for corporate Federal or State income taxes need be included in
      the
      Company’s financial statements.







**New
      Accounting Pronouncements**


In
      September 2006, the FASB issued SFAS No. 157, *Fair
      Value Measurements* (“SFAS
      No. 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 No. 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 Company is evaluating the impact of this new standard, but currently
      believes that adoption will not have a material impact on its financial
      position, results of operations, or cash flows.




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 Company is evaluating the impact of this new standard,
      but currently believes that adoption will not have a material impact on its
      financial position, results of operations, or cash flows.




-8-
 **KH
          FUNDING COMPANY** 
 **NOTES
            TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)**
 **FOR
            THE THREE AND** **NINE
            MONTHS ENDED SEPTEMBER 30, 2007 and 2006**





**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.




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





**September
                30,**
              **2007**
            
            **December
                31,**
              **2006****(unaudited)**
            
            ****Total
                recorded investment in impaired loans
            
            $
            550,997
            
            $
            651,895Amount
                of that recorded investment for which there is a related allowance
                for
                loan losses
            
            $
            550,997
            
            $
            631,289Amount
                of related allowance for loan losses associated with such
                investment
            
            $
            217,616
            
            $
            285,316Amount
                of that recorded investment for which there is no related allowance
                for
                loan losses
            
            $
            -
            
            $
            20,606





-9-
 **KH
          FUNDING COMPANY** 
 **NOTES
            TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)**
 **FOR
            THE THREE AND** **NINE
            MONTHS ENDED SEPTEMBER 30, 2007 and 2006**






**For
                the nine months**
              **ended**
              **September
                30,**
              **2007**
            
            **For
                the year**
              **ended**
              **December
                31,**
              **2006****(unaudited)**
            
            ****Average
                recorded investment in impaired loans during period
            
            $
            601,446
            
            $
            744,142Related
                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
            
            $
            -
            
            $
            -





As
      of
      September 30, 2007 and December 31, 2006, the Company had loans of $1,085,753
      and $1,748,342, respectively, which were more than ninety days past due and
      for
      which the Company continues to accrue interest. The Company has adequate
      collateral for these loans and management believes that both the principal
      and
      the related accrued interest are collectible.




**Analysis
      of the allowance for loan losses is as follows:**





**For
                the nine months**
              **ended**
              **September
                30,**
              **2007**
            
            **For
                the nine months**
              **ended**
              **September
                30,**
              **2006****(unaudited)**
            
            **(unaudited)**Beginning
                balance
            
            $
            452,154
            
            $
            369,791Provision
                for loan losses
            
            
            195,000
            
            
            119,272Loans
                charged off
            
            
            (232,800
            )
            
            (62,939
            )Ending
                Balance
            
            $
            414,354
            
            $
            426,124






**NOTE
      D --- INVESTMENTS**




As
      of
      September 30, 2007, the Company had no marketable securities. However,
      marketable securities consisted of the following, December 31,
      2006:





**December
                31, 2006****Amortized**
              **Cost**
            
            **Gross**
              **Unrealized**
              **Gains**
            
            **Gross**
              **Unrealized**
              **Losses**
            
            **Estimated**
              **Fair**
              **Value**Corporate
                bonds (net of premium)
            
            $
            615,317
            
            $
            -
            
            $
            (34,168
            )
            $
            581,149




The
      corporate bond position held at December 31, 2006 was sold in total on August
      24, 2007, incurring a loss of $52,267.




In
      addition, other investments available for sale of $50,872 at September 30,
      2007
      and December 31, 2006 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**




The
      following related party transactions exist as of the dates shown
      below:




Included
      in notes receivable at September 30, 2007 and December 31, 2006, are 13 notes
      totaling $10,416,315 and 14 notes totaling $9,571,428, respectively, from
      officers, stockholders and a company controlled by an officer. These notes
      all
      have annual maturities and are due in full on the maturity date unless extended
      by the Company. The interest rates on these notes range between 5.99% and 12.5%.
      The majority (98.3%) of these notes receivable were due from one shareholder
      who
      owed $9,739,309 as of September 30, 2007.




-10-
 **KH
          FUNDING COMPANY** 
 **NOTES
            TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)**
 **FOR
            THE THREE AND** **NINE
            MONTHS ENDED SEPTEMBER 30, 2007 and 2006**


Included
      in the notes payable and other loans payable balances at September 30, 2007
      and
      December 31, 2006, are 67 notes totaling $11,924,898 and 63 notes totaling
      $7,421,423, respectively, which are held by officers and stockholders. These
      notes were all issued at the rate in effect for the applicable term selected
      as
      of the date the note was issued.




During
      the nine months ended September 30, 2007, we borrowed $24,588,566 from fifteen
      of our shareholders and one high net worth individual on a short-term basis.
      We
      repaid $17,904,018 of the sums borrowed during the nine months ended September
      30, 2007 and the remaining $6,684,548 is included in other loans payable as
      of
      September 30, 2007. The majority of the borrowings were with one shareholder
      who
      was owed $5,503,488 as of September 30, 2007. This debt is due and payable
      upon
      demand.




There
      is
      a note receivable included in other receivables of $185,450, shown on the
      balance sheet at September 30, 2007 and December 31, 2006 as contra-equity,
      made
      to the Company's CEO for the purchase of 100,000 shares of stock in the Company.
      The interest rate on this loan is seven percent. The stock has a book value
      of
      about $51,000 as of September 30, 2007. At September 30, 2007 and December
      31,
      2006, there was no accrued interest receivable on this loan.




Included
      in the notes receivable at September 30, 2007 are six loans in the amount of
      $9,739,309 for the benefit of a significant shareholder. The majority of these
      loans ($8.68 million) were made during the year ended December 31, 2006 and
      $1.06 million were made during the nine months ended September 30, 2007. The
      proceeds of these loans were used to purchase real estate which serves as
      security for the loans. 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), KH Funding 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 KH
      Funding in advance.




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.




**NOTE
      F--** **STOCK
      BASED COMPENSATION**




We
      have
      granted stock-based compensation awards to employees and board members. Awards
      may consist of common stock or stock options. Our stock options have a five
      year
      life. These incentive stock options vest over three years in three equal annual
      installments. The stock options we grant provide for option exercise prices
      equal to or greater than the fair market value of the common stock at the date
      of the grant. Management determines the fair market value of the common stock
      at
      that date.





No
      stock
      options were granted during the nine months ended September 30, 2007. During
      the
      nine months ended September 30, 2006, 150,000 options were issued to four
      employees of which 70,000 options were forfeited on July 15, 2007. In addition,
      60,000 options expired on September 10, 2007. We accrue related compensation
      expenses as our options vest in accordance with SFAS123(R), *Share-Based
      Payment.* We
      recognized $15,500 and $36,700 stock-based compensation expense during the
      nine
      months ended September 30, 2007 and 2006, respectively, from the vesting of
      stock options we issued in earlier periods. Stock-based compensation includes
      the value of stock granted to non-independent board members for their service.
      This portion of the stock-based compensation expense was zero and $29,700,
      respectively.


-11-
 **KH
          FUNDING COMPANY** 
 **NOTES
            TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)**
 **FOR
            THE THREE AND** **NINE
            MONTHS ENDED SEPTEMBER 30, 2007 and 2006**






A
      summary
      of stock option activity during the nine months ended September 30, 2007 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, 2007
            
            
            471,250
            
            $
            2.40
            
            
            
            
            $
            282,750Granted
            
            
            -Exercised
            
            
            -Forfeited
                or expired
            
            
            130,000
            
            $
            2.54
            
            
            
            
            
            -Outstanding
                at September 30, 2007
            
            
            341,250
            
            
            
            
            
            2.51
            
            $
            51,188Exercisable
                at September 30, 2007
            
            
            287,917
            
            $
            2.20
            
            
            2.28
            
            $
            86,375







**NOTE
      G—COMMITMENTS AND CONTINGENT LIABILITIES**





**Off-Balance
      Sheet Arrangements**




We
      enter
      into off-balance sheet arrangements in the normal course of our business. These
      arrangements consist primarily of our loans which are lines-of-credit or
      draw-type loans. At September 30, 2007 we had $6.99 million in loans of this
      type. The unused or unfunded amount on these types of loans totaled $1.28
      million as of September 30, 2007.





-12-




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




**Management's
      Discussion and Analysis or Plan of Operation and other sections of this Report
      contain "forward-looking statements," as that term is defined in the Private
      Securities Litigation Reform Act of 1995, that 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. Such
      forward-looking statements are made pursuant to the safe harbor provisions
      of
      the Private Securities Litigation Reform Act of 1995. These statements are
      not
      guarantees of future performance and involve certain risks and uncertainties
      that are difficult to predict. Therefore, actual future results and trends
      may
      differ materially from what is indicated in forward-looking statements due
      to a
      variety of factors. 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. The 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.**




**Overview**




We
      conduct our business operations from our headquarters in Silver Spring,
      Maryland. Our primary business activities consist of originating, acquiring
      and
      servicing mortgage loans, and issuing interest-bearing debt securities to
      investors, referred to as "investor Notes". We purchase first and second trust
      residential loans nationwide from other lenders and banks. We also directly
      originate small commercial real estate mortgage loans and investment property
      residential mortgage loans.




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





In
      prior
      years 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 will 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 enables 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.




Historically,
      we have financed our operations through the sale of investor Notes to the public
      both directly and through select, contracted NASD Broker-Dealers. Our
      distribution plan was successful, establishing nearly 700 new investment
      accounts providing over $25 million in funds in 2005 and $12.5 million in funds
      during the first four months of 2006. However, since the public offering for
      our
      investor Notes expired in the second quarter of 2006 we ceased our public
      offering of Notes to new investors, except for the redeemed or rescinded sales
      as discussed below. In addition, the Company has continued to renew investors’
Fixed Term Notes upon expiration of the original contractual term of the Notes,
      unless the investor affirmatively requested that the Note be paid off. During
      2007, the Company renewed approximately $5.75 million in principal amount of
      Fixed Term Notes in this manner. The Company believes that these renewals
      qualified for an exemption from registration under Section 3(a)(9) of the
      Securities Act of 1933 (the “Securities Act”).





-13-


Also,
      as
      disclosed in our Annual Report on Form 10-KSB for the year ended December 31,
      2006, we exercised our right to make a mandatory call of Notes from certain
      holders of investor Notes that are residents of states in which our offering
      was
      not then registered or otherwise may not have been qualified under those states’
blue sky laws and redeemed a total of $1.47 million in principal and interest
      amounts of investor Notes during late December 2006 and early January 2007.
      Subsequent to March 31, 2007, a small number of accredited investors, most
      of
      whom are affiliates of the Company or pre-existing Note holders, elected to
      retain their investor Notes of approximately $3.1 million in aggregate principal
      amount, and the Company redeemed approximately $450,000 in principal amount
      of
      investor Notes held by other investors. The Securities and Exchange Commission
      (“SEC”) has notified the Company that it must withdraw its Registration
      Statement No. 333-135330 filed with the SEC in August 2006 and amended in
      November 2006 prior to December 14, 2007 unless the Company files a
      post-effective amendment by that date updating the financial statements and
      other disclosures as required by the Securities Act. Otherwise, the SEC will
      declare the registration statement to be abandoned. The Company is working
      toward filing a new registration statement to register the public offering
      of
      Notes under the Securities Act, and intends to register a public offering of
      Notes by coordination in the State of Maryland and selected other states in
      order to resume the public offering of investor Notes during the 4th quarter
      of
      2007. However, we cannot provide any assurance that the SEC, the State of
      Maryland or other states will declare our registration statement effective
      on a
      timely basis or at all. If we are not successful in resuming our public offering
      of Notes then we may need to significantly curtail our business and lending
      operations or stop making new loans or take other steps to provide additional
      liquidity. See “-Liquidity and Capital Resources.”





Recently,
      the sub-prime mortgage banking environment has been experiencing considerable
      strain from rising delinquencies and liquidity pressures. Several high profile
      sub-prime mortgage lenders have failed. The increased scrutiny of the sub-prime
      lending market is one of the factors that have impacted general market
      conditions, as well as several significant sub-prime mortgage originators.
      Although we engage as part of our business in what may be referred to as
      sub-prime lending, we believe that our exposure to problems in the industry
      is
      limited as a result of several factors. First, we believe that we are
      underwriting our sub-prime mortgage loans to a higher standard than the failing
      and delinquent loans from the more aggressive lenders in the mortgage industry.
      Second, we do not offer the loan products that are receiving the harshest
      criticism from regulators, commentators and Congress. Notably, as a general
      matter, the sub-prime loans that we originate or purchase have loan to value
      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. Third, our size
      does not require us to generate or purchase high volumes of sub-prime mortgage
      loans so we can look much more closely at the individual borrowers, as in the
      case of loans that we originate. In the case of purchased loans, we rely on
      strict purchase criteria relating to LTV ratios and documentation. However,
      if
      there is a major downturn in real estate values and we experience significant
      loan defaults, we may not be able to prevent or materially diminish an adverse
      affect on our financial condition or results of operations.





**Recent
      Developments**





1.
      On
      July 12, 2007, a related party borrower, who is a significant stockholder of
      the
      Company, failed to make a payoff of interest of $208,113 and principal of $2.60
      million representing one of three loans secured by property in Baltimore,
      Maryland. The three loans totaled $5.69 million. The Company declared the
      borrower in default and instituted the default interest rate for the three
      loans. The borrower has stated that all interest will be paid in December 2007
      when the borrower’s financial condition is expected to have improved. The loans
      are secured by the subject properties and additional collateral and the Company
      does not anticipate any loss from this event. The related party borrower also
      has other loans outstanding totaling $3.08 million that are currently
      performing.




2.
      In
      July 2007, the Maryland Securities Division (the “Division”) submitted a draft
      Consent Order to the Company relating to the sale
      by
      the Company of investor Notes in Maryland and certain other states from May
      to
      November 2006.  The draft Consent Order recites that the Company offered
      and sold investor Notes at a time when the Company did not have an effective
      registration statement in Maryland, and as a result, the Company offered
      rescission to certain accredited investors (all of whom declined to rescind
      their Note purchases) and offered restitution to others through the redemption
      of Notes and the payment of principal and accrued interest.  The redemption
      and rescission offering was previously disclosed in the Company’s Form 10-KSB
      for the year ended December 31, 2006, as well as in the Form 10-QSB for the
      fiscal quarters ended March 31, 2007 and June 30, 2007.  Under the draft
      Consent Order, the Company and the Company’s Chief Executive Officer, Robert L.
      Harris, must (i) certify the results of the rescission offering and redemption,
      (ii) agree in future offerings to comply with all provisions of the Maryland
      Securities Act and the regulations promulgated thereunder, and (iii) until
      January 1, 2012, or any period in which the Company has a pending or effective
      registration statement on file with the Division, submit to the Division copies
      of all periodic reports and CEO certifications that are required to be filed
      with the Securities and Exchange Commission.  The Company has recently been
      in contact with the Division and anticipates entering into the proposed Consent
      Order in the near future .




-14-


3.
      On October 5, 2007, our Chief Financial Officer resigned. He was replaced on
      an
      interim basis by our Chief Executive Officer until a replacement is found.
      We
      are currently searching for a new Chief Financial Officer.




**Critical
      Accounting Policies**




Our
      significant accounting policies are disclosed in the footnotes to the financial
      statements included in the Company's Form 10-KSB for the year ended December
      31,
      2006. 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** **September
      30, 2007 and December 31, 2006**




*Assets* .
      Total
      assets decreased by $6,851,939, from $63,325,701 at December 31, 2006 to
      $56,473,762 at September 30, 2007. The size of our loan portfolio decreased
      $4,507,118 ending at $50,196,902. Cash decreased $3,657,290, from $3,823,013
      at
      December 31, 2006 to $165,723 at September 30, 2007. The decrease in total
      assets is primarily a result of the expiration of our offering for the sale
      of
      investor Notes in the second quarter of 2006 while at the same time we have
      continued to make redemptions on Investor Notes. See "Liquidity and Capital
      Resources".




*Liabilities* .
      Total
      liabilities decreased by $6,820,976, from  $61,907,387
      at December 31, 2006 to $55,086,411 at September 30, 2007. The net decrease
      was
      primarily due to a decrease (redemptions) of $13,501,443 in investor Notes,
      offset by an increase of $6,684,548 in other loans payable.




*Equity* .
      Total
      stockholders' equity decreased by $30,963 from $1,418,314 at December 31, 2006
      to $1,387,351 at September 30, 2007. The decrease was due to cash dividend
      distributions of $164,028, offset by $15,500 in stock-based compensation, $856
      in stock sold, net income of $82,537, and the elimination of accumulated other
      comprehensive loss of $34,168 by the sale of marketable securities.




*Past
      Due Loans* .
      We
      generally purchase or make "hard collateral" loans, based largely on collateral
      value and in which the loan amount is below 70% of the collateral value. As
      of
      September 30, 2007 we held nine loans that were more than 90 days past due
      but
      are still accruing interest. The total principal and interest due on these
      loans
      was $1,085,753. Six of the loans, totaling $1,014,448, are first trust real
      estate loans on which we do not expect to suffer any loss due to collateral
      value, and we anticipate that the other three loans of $71,305 will move to
      current status in the near future. We continue to accrue interest on these
      loans
      based on the underlying collateral value and payment history. We monitor these
      loans on a continual basis.




-15-


*Non-Accrual
      Loans* .
      As of
      September 30, 2007, there were 14 loans in non-accrual status with an
      outstanding principal balance totaling $550,997. The majority of these loans
      are
      first trust loans that are well collateralized based on recent valuations.
      In
      the event we have to foreclose on any of these loans, we do not expect any
      loss
      in excess of specific reserves associated with the loans. We have a specific
      reserve of $217,616 and a general reserve of $196,738 as part of our total
      reserve of $414,354 for anticipated and unanticipated loan losses.




**Comparison
      of Operating Results for** **Nine
      Months Ended September 30, 2007 and 2006**




*Net
      interest margin.* The
      average yield earned on loans receivable was 10.74% for the nine months ended
      September 30, 2007 and 11.05% for the nine months ended September 30, 2006.
      The
      average rate paid on investor Notes increased to 7.07% for the nine months
      ended
      September 30, 2007 from 6.43% for the nine months ended September 30, 2006,
      due
      primarily to an increase in the contractual rates we are required to pay on
      investor Notes that have been renewed. Overall, the net margin on interest
      decreased to 3.67% for the nine months ended September 30, 2007, from 4.62 %
      for the
      nine months ended September 30, 2006. This net margin is calculated using
      contractual rates and excludes fee income and expense. The current net margin
      of
      3.67% is at or near its historical low. The Company does not expect any further
      significant decrease.




*Net
      Income* .
      Net
      income for the nine months ended September 30, 2007 was $82,537 compared to
      net
      income of $205,455 for the nine months ended September 30, 2006.




*Interest
      Income* .
      Total
      interest income was $4,568,795 for the nine months ended September 30, 2007,
      compared to $4,430,322 for the same period in 2006. The additional income
      resulted primarily from an increase in the average interest rate on loans
      receivable. The interest income includes point and fee income and interest
      earned on bank investments and marketable securities.




*Interest
      Expense* .
      Interest expense was $3,270,585 for the nine months ended September 30, 2007,
      and $2,910,264 for the corresponding period in 2006. The additional expense
      resulted primarily from an increase in the interest rates paid on investor
      Notes
      outstanding. 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 $195,000 for the nine months ended September
      30,
      2007, compared to $175,103 for the nine months ended September 30, 2006. 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 losses of $18,800 during the nine months ended September 30, 2007
      compared to losses of $101,258 for the corresponding period in 2006. The
      difference was primarily due to the later period having an increase in the
      rental income from other real estate owned and smaller losses on the sale of
      other real estate owned, offset only partially by losses on the sales of
      securities.




*Non-Interest
      Expense* .
      We
      experienced a decrease in non-interest expense to $1,001,873 for the nine months
      ended September 30, 2007 from $1,038,242 for the nine months ended September
      30,
      2006. Increases in salaries and wages and bank charges were more than offset
      by
      decreases in offering costs and various administration costs.




*Income
      Taxes* .
      KH
      Funding Company has 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.







-16-




**Comparison
      of Operating Results for Three Months Ended** **September
      30, 2007 and 2006**




*Net
      interest margin.* The
      average yield earned on loans receivable was 10.74% for the three months ended
      September 30, 2007 and 11.38% for the three months ended September 30, 2006.
      The
      average rate paid on investor Notes increased to 7.29% for the three months
      ended September 30, 2007 from 6.64% for the three months ended September 30,
      2006, 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 3.45%
      for the three months ended September 30, 2007, from 4.74% for the three months
      ended September 30, 2006. This net margin is calculated using contractual rates
      and excludes fee income and expense.




*Net
      Income/Loss* .
      Net
      loss for the three months ended September 30, 2007 was $94,593 compared to
      net
      income of $35,225 for the three months ended September 30, 2006.




*Interest
      Income* .
      Total
      interest income was $1,496,298 for the three months ended September 30, 2007,
      compared to $1,639,065 for the same period in 2006. The decrease in interest
      income was due primarily to a decrease of $127,077 in interest earned on loans
      between the two periods. This decrease was due to a decline in our loans
      receivable portfolio due to normal payoffs and limitations on loan originations.
      Interest income includes point and fee income and interest earned on bank
      investments and marketable securities.




*Interest
      Expense* .
      Interest expense was $1,116,327 for the three months ended September 30, 2007,
      and $1,078,502 for the corresponding period in 2006. The increase in interest
      expenses resulted primarily from interest on additional borrowing, and an
      increase in the interest rates paid on investor Notes outstanding that were
      renewed. 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 September
      30,
      2007, compared to $55,832 for the three months ended September 30, 2006. 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 losses of $42,153 during the three months ended September 30,
      2007
      compared to a loss of $109,034 for the corresponding period in 2006. The
      difference was primarily due to a decrease in the losses on the sale of other
      real estate owned and the sale of marketable securities.




*Non-Interest
      Expense* .
      We
      experienced a decrease in non-interest expense to $357,411 for the three months
      ended September 30, 2007 from $360,472 for the three months ended September
      30,
      2006. Increases in salaries and wages, professional fees, and insurance costs
      were more than offset by decreases in offering costs, real estate maintenance,
      and various administration costs in the current period as compared to the prior
      period.




*Income
      Taxes* .
      KH
      Funding Company has 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
      nine months ended September 30, 2007, net cash provided by operating activities
      was $1,712,361. The components of this were net income, depreciation, loan
      losses, fixed assets, compensation, and other non-cash charges, and an increase
      in interest payable, all totaling $2,235,872, offset by an increase in interest
      receivable, amortization and prepaid expenses.




For
      the
      nine months ended September 30, 2007, net cash provided by investing activities
      was $3,320,031 The expenditures included $10,999,339 for loans made to borrowers
      and $205,973 for payments on other receivables and purchases of property and
      equipment. These expenditures were offset by principal repayments from borrowers
      of $13,489,339 and proceeds received from the sale of real estate and marketable
      securities of $1,112,189 during the nine months ended September 30, 2007.




-17-


For
      the
      nine months ended September 30, 2007, net cash used in financing activities
      was
      $8,690,282. Net proceeds from other loans payable (borrowings) of $6,684,548
      and
      investor notes of $2,248,012, together with sales of common stock of $861 were
      offset by principal payments on investor notes of $17,407,737, a decrease in
      escrow and security deposits of $47,337, and dividend distributions and stock
      redemptions of $168,629.




During
      2007, the Company received money from the sales of its Notes and all such monies
      received have been returned to the investors. Also, during 2007, the Company
      has
      been able to raise cash by borrowing from some of its larger shareholders and
      a
      few high net worth individuals, all of which are considered to be "insiders."
      Also, as is discussed under "Overview" above, during 2007, the Company has
      renewed Fixed Term Notes held by investors upon maturity.




Historically
      KH Funding Company's primary sources of funding have been the proceeds from
      the
      sale of investor Notes, principal and interest payments received from loans
      receivable, 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. Our
      one-day and thirty day demand investor Notes can cause significant volatility
      in
      our cash balances. We contend with this volatility through our liquidity
      strategy which is discussed below.






The
      table
      below illustrates the sales of investor Notes versus redemptions for the years
      indicated:





**Year**
            
            **Notes
                Sold**
            
            **Notes
                Redeemed**
            
            **Percentage**2002
            
            $
            22,926,619
            
            $
            18,681,654
            
            
            81.48%2003
            
            $
            26,630,166
            
            $
            24,697,770
            
            
            92.74%2004
            
            $
            49,008,102
            
            $
            44,786,895
            
            
            91.39%2005
            
            $
            120,110,831
            
            $
            96,630,099
            
            
            80.45%2006
            
            $
            106,101,789
            
            $
            95,933,794
            
            
            90.42%






One
      of
      our primary liquidity needs is the funding of redemption requests on our one-day
      demand and thirty-day demand Notes. Only holders of one-day demand Notes can
      make redemption requests on less than thirty days notice, and we make an effort
      to keep funds available for these requests. Only holders of thirty-day demand
      Notes can make redemption requests on less than 90 days notice, and if the
      funds
      will not be available within thirty days, we would attempt to sell some of
      our
      loans receivable to have the funds available to meet requests for funds from
      these Note holders. All other types of Notes, that is the term notes of one,
      three and five years, are redeemable upon maturity, or prior to maturity on
      90
      days advance notice, subject to a penalty. If necessary, we would attempt to
      sell loans from our portfolio in bulk to fund redemption requests from our
      Note
      holders. However, any sale of loans must comply with the requirements of the
      Trust Indenture Act of 1939, may require the consent of the trustee for investor
      Notes and would further be subject to market conditions. As a result of these
      legal and market factors we may not be able to sell mortgage loans from our
      portfolio in order to meet redemption requests. If we are unable to obtain
      liquidity to meet redemption requests we may become in default on the Notes,
      which would permit, but not require, the indenture Trustee to accelerate the
      maturity of the Notes, declare all the Notes immediately due and payable, and
      take other actions permitted by the indenture for the Notes.




The
      Company has never been unable to meet a redemption request, although this does
      not guarantee that the Company will have sufficient liquidity to meet all
      redemption requests in the future. We normally hold 3% to 7% of our assets
      in
      cash and cash equivalents to fund redemptions of one-day demand Notes. This
      amount has historically been sufficient for us to meet our redemption
      obligations. At September 30, 2007, the Company had cash and cash equivalents
      of
      $165,723, or 0.29% of total assets, a historically low level. The day after
      the
      close of the period, on October 1, 2007, the Company received a loan payoff
      of
      $600,000 that was expected.




-18-


As
      noted
      above, our public offering of investor Notes expired in the second quarter
      of
      2006, pending the filing of a new Registration Statement. We currently expect
      to
      resume our public offering of investment Notes by late 2007 in selected states.
      In order to resume any public offering of investor Notes, we will need to obtain
      the consent of the Maryland Securities Division.




*Redemption
      of Notes.* As
      disclosed in our Annual Report on Form 10-KSB for the year ended December 31,
      2006 and in early 2007 we recently exercised our right to make a mandatory
      call
      of Notes from certain holders of investor Notes that are residents of states
      in
      which our offering was not then registered or otherwise may not have been
      qualified under those states’ blue sky laws. Accordingly, we redeemed a total of
      $1.47 million in principal and interest amounts of investor Notes during late
      December 2006 and early January 2007. Subsequent to March 31, 2007, a small
      number of accredited investors, most of whom are affiliates of the Company
      or
      pre-existing Note holders, elected to retain their investor Notes of
      approximately $3.1 million in aggregate principal amount, and the Company
      redeemed approximately $450,000 in principal amount of investor Notes held
      by
      other investors.






**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 2.5% at September 30, 2007.
      During this time period total stockholders' equity in dollars has remained
      fairly constant while total assets in dollars have increased, causing the
      equity-to-assets ratio to decrease. Although the ratio has decreased compared
      to
      what it has been in the past, management believes that the present ratio remains
      adequate. In future periods the Company expects dividends to stockholders to
      be
      less than the net income in order to inhibit further decreases in stockholders'
      equity and also the Company would consider reducing or eliminating dividends
      in
      order to preserve Stockholders’ Equity.




**ITEM
      3.**  **CONTROLS
      AND PROCEDURES**




As
      of the
      end of the period covered by this Form 10-QSB, our management, with the
      participation of our Chief Executive Officer and our Chief Financial Officer,
      carried out an evaluation of the effectiveness of the design and operation
      of
      our disclosure controls and procedures (as defined in Rules 13a-15(e) and
      15d-15(e) under the Securities Exchange Act of 1934). Based upon that
      evaluation, our Chief Executive Officer and our Chief Financial Officer
      concluded that our disclosure controls and procedures are effective as of the
      end of the period covered by this report.




There
      were no changes in the Company's internal control over financial reporting
      during the nine months ended September 30, 2007 that have materially affected,
      or are reasonably likely to materially affect, our 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 Circuit
      Court of Montgomery County, Maryland) by a company known as SBM Financial,
      LLC
      ("SBM"). SBM claims to operate a business similar to ours. SBM claims that
      we
      have intentionally interfered with the ability of SBM to retain their existing
      investors. Recently, the SEC requested that a receiver be appointed to liquidate
      the assets of SBM. We believe that the SBM lawsuit is groundless. At present,
      we
      expect no material impact on KH Funding as a result of this litigation.




-19-


In
      July
      2007, the Maryland Securities Division (the “Division”) submitted a draft
      Consent Order to the Company relating to the sale
      by
      the Company of investor Notes in Maryland and certain other states from May
      to
      November 2006.  The draft Consent Order recites that the Company offered
      and sold investor Notes at a time when the Company did not have an effective
      registration statement in Maryland, and as a result, the Company offered
      rescission to certain accredited investors (all of whom declined to rescind
      their Note purchases) and offered restitution to others through the redemption
      of Notes and the payment of principal and accrued interest.  The redemption
      and rescission offering was previously disclosed in the Company’s Form 10-KSB
      for the year ended December 31, 2006, as well as in the Form 10-QSB for the
      fiscal quarters ended March 31, 2007 and June 30, 2007.  Under the draft
      Order, the Company and the Company’s Chief Executive Officer, Robert L. Harris,
      must (i) certify the results of the rescission offering and redemption, (ii)
      agree in future offerings to comply with all provisions of the Maryland
      Securities Act and the regulations promulgated thereunder and (iii) until
      January 1, 2012, or any period in which the Company has a pending or effective
      registration statement on file with the Division, submit to the Division copies
      of all periodic reports and CEO certifications that are required to be filed
      with the Securities and Exchange Commission.  The Company has certified the
      results of the recission offering and redemption, and expects to enter into
      the
      Consent Order in the near future .






Item
      2.
      Unregistered Sales of Securities and Use of Proceeds




Not
      applicable.




Item
      3.
      Defaults Upon Senior Securities




Not
      applicable.




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




Not
      applicable.




Item
      5.
      Other Information




Not
      applicable.




Item
      6.
      Exhibits and Report on Form 8-K




(a)
            Exhibits




Exhibit
              31.1 -
            Certification
                by the Chief Executive Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002




Exhibit
              31.2 -
            Certification
                by the Chief Financial Officer Pursuant to Section 302 of the
                Sarbanes-Oxley Act of 2002




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




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




(b)  Reports
      on Form 8-K




Exhibit
              5.02 -
            Resignation
                of the Chief Financial Officer and Designation of Interim Chief Financial
                Officer





-20-


**SIGNATURE**




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





KH
                FUNDING COMPANY(Registrant)Dated:
                November 19, 2007
            /s/
                Robert L. HarrisRobert
                L. HarrisChief
                Financial Officer (Interim)




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





-21-