**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 June 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 August 31, 2007**Common
                Stock, $0.01 par value per share
            
            2,727,281




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






















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


**ITEM
                1.****FINANCIAL
                STATEMENTS**
            **PAGE
                NOS.**BALANCE
                SHEETS - June 30, 2007 (UNAUDITED) and December 31, 2006
            3STATEMENTS
                OF OPERATIONS (UNAUDITED), for the three and six months ended June
                30,
                2007 and 2006
            4STATEMENTS
                OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED), for the six months ended
                June 30, 2007 and 2006
            5STATEMENTS
                OF CASH FLOWS (UNAUDITED), for the six months ended June 30, 2007
                and
                2006
            6-7NOTES
                TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)
            8-12





2


**KH
      FUNDING COMPANY**


**BALANCE
      SHEETS**





**June
                30,**
              **2007**
            
            **December
                31,**
              **2006****(unaudited)**
            
            ******Assets**Cash
            
            $
            632,079
            
            $
            3,823,013Investments
                available for sale:Marketable
                securities - at fair value
            
            
            589,569
            
            
            581,149Other
            
            
            50,872
            
            
            50,872Loans,
                less allowance for loan losses of $419,516(2007)
                and $452,154 (2006)
            
            
            53,851,459
            
            
            54,704,020Accrued
                interest receivable
            
            
            2,302,158
            
            
            1,961,683Other
                receivables
            
            
            263,335
            
            
            611,397Prepaid
                expenses
            
            
            235,324
            
            
            294,496Property
                and equipment - Net
            
            
            168,125
            
            
            143,419Real
                estate owned:Rental
                property
            
            
            745,111
            
            
            814,441Held
                for sale
            
            
            204,087
            
            
            325,223Other
                assets
            
            
            15,988
            
            
            15,988**Total
                Assets**
            
            $
            59,058,107
            
            $
            63,325,701**Liabilities
                and Stockholders' Equity****Liabilities**Notes
                and accrued interest payable
            
            $
            49,138,351
            
            $
            61,774,343Other
                loans payable
            
            
            8,260,766
            
            
            -Accounts
                payable and accrued expenses
            
            
            23,185
            
            
            21,980Escrows
                and security deposits
            
            
            149,643
            
            
            111,064**Total
                Liabilities**
            
            
            57,571,945
            
            
            61,907,387**Stockholders'
                Equity**Common
                stock (5,000,000 shares authorized; 2,727,281 shares (2007) and 2,726,951
                shares (2006) issued and outstanding, $0.01 par value)
            
            
            27,273
            
            
            27,269Paid-in
                capital
            
            
            1,783,056
            
            
            1,879,783Accumulated
                deficit
            
            
            (112,241
            )
            
            (269,120
            )Subscription
                note receivable
            
            
            (185,450
            )
            
            (185,450
            )Accumulated
                other comprehensive loss
            
            
            (26,476
            )
            
            (34,168
            )**Total
                Stockholders' Equity**
            
            
            1,486,162
            
            
            1,418,314**Total
                Liabilities and Stockholders' Equity**
            
            $
            59,058,107
            
            $
            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
                June 30,**
            
            **For
                the Six**
              **Months**
              **Ended
                June 30,****2007**
            
            **2006**
            
            **2007**
            
            **2006****Interest
                Income**Interest
                and fees on loans
            
            $
            1,532,229
            
            $
            1,423,895
            
            $
            3,048,058
            
            $
            2,684,098Interest
                on bank accounts
            
            
            377
            
            
            53,887
            
            
            5,711
            
            
            96,952Interest
                on investments —marketable securities
            
            
            7,346
            
            
            7,737
            
            
            18,728
            
            
            15,464Total
                interest income
            
            
            1,539,952
            
            
            1,485,519
            
            
            3,072,497
            
            
            2,796,514**Interest
                Expense**Interest
                and fees on Notes
            
            
            928,615
            
            
            985,041
            
            
            1,935,049
            
            
            1,837,020Interest
                on other loans
            
            
            141,326
            
            
            -
            
            
            219,209
            
            
            -Total
                interest expense
            
            
            1,069,941
            
            
            985,041
            
            
            2,154,258
            
            
            1,837,020Net
                interest income
            
            
            470,011
            
            
            500,478
            
            
            918,239
            
            
            959,494**Provision
                for Loan Losses**
            
            
            75,000
            
            
            61,920
            
            
            120,000
            
            
            119,272**Net
                Interest Income after Provision for Loan Losses**
            
            
            395,011
            
            
            438,558
            
            
            798,239
            
            
            840,222**Non-interest
                Income**Rental
                income
            
            
            15,416
            
            
            14,243
            
            
            29,521
            
            
            24,759Loss
                on sale of real estate
            
            
            (11,872
            )
            
            (25,687
            )
            
            (11,872
            )
            
            (25,687
            )Other
            
            
            2,736
            
            
            4,284
            
            
            5,704
            
            
            9,428Total
                non-interest income (loss)
            
            
            6,280
            
            
            (7,160
            )
            
            23,353
            
            
            8,500**Non-interest
                Expense**Salaries
                and wages
            
            
            125,665
            
            
            98,347
            
            
            246,352
            
            
            193,955Professional
                fees
            
            
            33,903
            
            
            54,231
            
            
            64,380
            
            
            83,679Offering
                costs
            
            
            36,000
            
            
            57,617
            
            
            83,402
            
            
            113,825Administration
            
            
            3,813
            
            
            43,835
            
            
            42,520
            
            
            81,452Real
                estate maintenance
            
            
            53,723
            
            
            25,391
            
            
            78,298
            
            
            45,791Insurance
            
            
            16,063
            
            
            18,906
            
            
            28,630
            
            
            38,291Depreciation
            
            
            14,782
            
            
            14,273
            
            
            28,827
            
            
            29,136Rent
            
            
            28,968
            
            
            28,679
            
            
            57,973
            
            
            60,494Bank
                charges
            
            
            11,983
            
            
            5,964
            
            
            20,623
            
            
            12,408Other
            
            
            3,876
            
            
            9,059
            
            
            13,708
            
            
            19,461Total
                non-interest expense
            
            
            328,776
            
            
            356,302
            
            
            664,713
            
            
            678,492**Net
                Income (Loss)**
            
            $
            72,515
            
            $
            75,096
            
            $
            156,879
            
            $
            170,230Basic
                earnings per share
            
            $
            0.03
            
            $
            0.03
            
            $
            0.06
            
            $
            0.06Diluted
                earnings per share
            
            
            0.03
            
            
            0.03
            
            
            0.06
            
            
            0.06Cash
                dividends paid per common share
            
            
            0.02
            
            
            0.02
            
            
            0.04
            
            
            0.04





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


4


**KH
      FUNDING COMPANY**


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


**FOR
      THE SIX MONTHS ENDED JUNE 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
                Based Compensation Expense**
            
            
            -
            
            
            -
            
            
            11,500
            
            
            -
            
            
            -
            
            
            -
            
            
            11,500**Dividends
                Paid $0.04 per share**
            
            
            -
            
            
            -
            
            
            (109,083
            )
            
            -
            
            
            -
            
            
            -
            
            
            (109,083
            )**Comprehensive
                income**Net
                income for period ended June 30, 2007
            
            
            -
            
            
            -
            
            
            -
            
            
            156,879
            
            
            -
            
            
            -
            
            
            156,879Change
                in fair value of investments
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            7,692
            
            
            7,692**Total
                Comprehensive Income for the Period**
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            164,571**Balances
                at June 30, 2007**
            
            
            2,727,281
            
            $
            27,273
            
            $
            1,783,056
            
            $
            (112,241
            )
            $
            (185,450
            )
            $
            (26,476
            )
            $
            1,486,162**Balances
                at January 1, 2006**
            
            
            2,555,556
            
            $
            25,556
            
            $
            1,603,852
            
            $
            (429,688
            )
            $
            (185,450
            )
            $
            (99,463
            )
            $
            914,807**Additional
                Stock Issued**
            
            
            168,828
            
            
            1,687
            
            
            466,072
            
            
            -
            
            
            -
            
            
            -
            
            
            467,759**Stock
                Based Compensation Expense**
            
            
            5,567
            
            
            56
            
            
            15,369
            
            
            
            
            
            
            
            
            
            
            
            15,425**Dividends
                Paid $0.04 per share**
            
            
            
            
            
            
            
            
            (105,109
            )
            
            
            
            
            
            
            
            
            
            
            (105,109
            )**Comprehensive
                income**Net
                income for period ended June 30, 2006
            
            
            -
            
            
            -
            
            
            -
            
            
            170,230
            
            
            -
            
            
            -
            
            
            170,230Change
                in fair value of investments
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            29,736
            
            
            29,736**Total
                Comprehensive Income for the Period**
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            -
            
            
            199,966**Balances
                at June 30, 2006**
            
            
            2,729,951
            
            $
            27,299
            
            $
            1,980,184
            
            $
            (259,458
            )
            $
            (185,450
            )
            $
            (69,727
            )
            $
            1,492,848





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





5




**KH
      FUNDING COMPANY**


**STATEMENTS
      OF CASH FLOWS (UNAUDITED)**





**For
                the Six Months Ended June 30,****2007**
            
            **2006****Cash
                from Operating Activities**Net
                income
            
            $
            156,879
            
            $
            170,230**Adjustments
                to reconcile net income to net cash from operating
                activities:**Depreciation
            
            
            28,827
            
            
            29,136Amortization
                of loan fees
            
            
            (57,000
            )
            
            (80,000
            )Provision
                for loan losses
            
            
            120,000
            
            
            119,272Loss
                on sale of real estate owned
            
            
            11,872
            
            
            25,687Stock-based
                compensation expense
            
            
            11,500
            
            
            15,425**Changes
                in Operating Assets and Liabilities:**Interest
                receivable
            
            
            (340,475
            )
            
            (341,419
            )Prepaid
                offering costs
            
            
            50,014
            
            
            113,825Prepaid
                expenses
            
            
            36,211
            
            
            (103,718
            )Unamortized
                brokerage fees
            
            
            (2,881
            )
            
            -Deferred
                loan origination costs
            
            
            4,320
            
            
            (12,523
            )Increase
                in other assets
            
            
            
            
            
            (10,844
            )Accounts
                payable and accrued expenses
            
            
            1,205
            
            
            10,378Accrued
                late charges
            
            
            (6,479
            )
            
            (7,323
            )Interest
                payable (included in notes payable)
            
            
            1,170,799
            
            
            1,059,680**Net
                Cash Provided by Operating Activities:**
            
            
            1,184,792
            
            
            987,806**Cash
                Flows from Investing Activities**Principal
                repayments from borrowers
            
            
            7,127,337
            
            
            13,762,291Loans
                made to borrowers
            
            
            (6,669,592
            )
            
            (17,875,678
            )Loans
                purchased
            
            
            -
            
            
            (6,106,550
            )Purchase
                of marketable securities and other investments
            
            
            (728
            )
            
            (22,565
            )Collections
                (payments) for other receivables
            
            
            381,193
            
            
            (663,805
            )Proceeds
                from sale of other real estate owned
            
            
            478,472
            
            
            28,000Purchase
                of property and equipment
            
            
            (41,889
            )
            
            (13,181
            )Payments
                on other real estate owned
            
            
            (4,600
            )
            
            (7,147
            )**Net
                Cash Provided by (Used in) Investing Activities**
            
            
            1,270,193
            
            
            (10,898,635
            )**Cash
                Flows from Financing Activities**Proceeds
                from investor notes
            
            
            1,568,912
            
            
            65,067,038Proceeds
                from other loans
            
            
            23,322,450
            
            
            31,500Principal
                payments on investor notes
            
            
            (15,697,823
            )
            
            (56,808,808
            )Proceeds
                from sales of common stock
            
            
            860
            
            
            483,184Payments
                on other loans
            
            
            (14,736,683
            )Payment
                of dividends
            
            
            (109,083
            )
            
            (105,109
            )(Decrease)
                Increase in escrow and security deposits
            
            
            5,448
            
            
            36,413**Net
                Cash (Used in) Provided by Financing Activities**
            
            
            (5,645,919
            )
            
            8,704,218**Net
                Decrease in Cash**
            
            
            (3,190,934
            )
            
            (1,206,611
            )**Cash
                Balance,**beginning of period
            
            
            3,823,013
            
            
            6,579,242**Cash
                Balance, e**nd
                of period
            
            $
            632,079
            
            $
            5,372,631**Supplemental
                Cash Flow Information:**Interest
                paid
            
            $
            983,459
            
            $
            778,064Transfer
                of loans to other real estate owned
            
            $
            306,922
            
            $
            236,483





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





6


**KH
      FUNDING COMPANY**





**NOTES
      TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)**


**FOR
      THE THREE AND SIX MONTHS ENDED JUNE 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 six month periods ended
      June 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**




**Critical
      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 Operation**




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 June 30, 2007 and June 30, 2006 the Company
      had 471,250 and 321,250 options outstanding, respectively. For the six months
      ended June 30, 2007 and 2006 50,000 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 SIX MONTHS ENDED JUNE 30, 2007 and 2006**


**For
                The Three**
              **Months
                Ended**
              **June
                30,**
            
            **For
                The Six**
              **Months
                Ended**
              **June
                30,****2007**
            
            **2006**
            
            **2007**
            
            **2006****(unaudited)**
            
            **(unaudited)**Basic:Net
                income (attributable to common stock)
            
            $
            72,515
            
            $
            75,096
            
            $
            156,879
            
            $
            170,230Weighted
                average common shares outstanding
            
            
            2,727,190
            
            
            2,701,929
            
            
            2,727,071
            
            
            2,638,435Basic
                earnings per share
            
            $
            0.03
            
            $
            0.03
            
            $
            0.06
            
            $
            0.06Diluted:Net
                income (attributable to common stock)
            
            $
            72,515
            
            $
            75,096
            
            $
            156,879
            
            $
            170,230Weighted
                average common shares outstanding
            
            
            2,727,190
            
            
            2,701,929
            
            
            2,727,071
            
            
            2,638,435Dilutive
                effect of stock options
            
            
            98,750
            
            
            98,749
            
            
            98,750
            
            
            105,085Weighted
                average common shares outstanding-diluted
            
            
            2,825,940
            
            
            2,800,678
            
            
            2,825,821
            
            
            2,743,520Diluted
                earnings per share
            
            $
            0.03
            
            $
            0.03
            
            $
            0.06
            
            $
            0.06





**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 Options 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 SIX MONTHS ENDED JUNE 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
      loan 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:**





**June
                30,**
              **2007**
            
            **December
                31,**
              **2006****(unaudited)**
            
            ****Total
                recorded investment in impaired loans
            
            $
            520,376
            
            $
            651,895Amount
                of that recorded investment for which there is a related allowance
                for
                loan losses
            
            $
            520,376
            
            $
            631,289Amount
                of related allowance for loan losses associated with such
                investment
            
            $
            188,495
            
            $
            285,316Amount
                of that recorded investment for which there is no related allowance
                for
                loan losses
            
            $
            -
            
            $
            20,606





**For
                the six months**
              **ended
                June 30,**
              **2007**
            
            **For
                the year ended**
              **December
                31,**
              **2006****(unaudited)**
            
            ****Average
                recorded investment in impaired loans during period
            
            $
            586,136
            
            $
            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
            
            $
            -
            
            $
            -





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


As
      of
      June 30, 2007 and December 31, 2006, the Company had loans of $1,227,785 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 six months**
              **ended
                June 30,**
              **2007**
            
            **For
                the six months**
              **ended
                June 30,**
              **2006****(unaudited)**
            
            **(unaudited)**Beginning
                balance
            
            $
            452,154
            
            $
            369,791Provision
                for loan losses
            
            
            120,000
            
            
            119,272Loans
                charged off
            
            
            (152,638
            )
            
            (62,939
            )Ending
                Balance
            
            $
            419,516
            
            $
            426,124






**NOTE
      D --- INVESTMENTS**




Marketable
      securities consist of the following at the dates indicated:





**June
                30, 2007****Amortized
                Cost**
            
            
            
            **Gross
                Unrealized Gains**
            
            
            
            **Gross
                Unrealized Losses**
            
            
            
            **Estimated
                Fair**
              **Value**Corporate
                bonds (net of premium)
            
            $
            616,045
            
            
            $
            -
            
            
            $
            (26,476)
            
            
            $
            589,569





**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




In
      addition, other investments available for sale of $50,872 at June 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 June 30, 2007 and December 31, 2006, are 13 notes
      totaling $9,461,555 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 (92.8%) of these notes receivable were due from one shareholder
      who
      owed $8,782,918 as of June 30, 2007.




Included
      in the notes payable and other loans payable balances at June 30, 2007 and
      December 31, 2006, are 69 notes totaling $12,711,856 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 six months ended June 30, 2007, we borrowed $22,997,450 from fifteen of
      our
      shareholders and one high net worth individual on a short-term basis. We repaid
      $14,736,683 of the sums borrowed during the six months ended June 30, 2007
      and
      the remaining $7,935,766 is included in other loans payable as of June 30,
      2007.
      The majority of the borrowings were with one shareholder who was owed $6,803,890
      as of June 30, 2007. This debt is due and payable upon demand.




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


There
      is
      a note receivable included in other receivables of $185,450, shown on the
      balance sheet at June 30, 2007 and December 31, 2006 as a 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 $52,000 as of June 30, 2007. At June 30, 2007 and December 31, 2006,
      there
      was $3,245 and 0 accrued interest receivable on this loan. Also included in
      Other Receivables is a short-term loan to Mr. Harris in the amount of $160,300,
      which was repaid in early July 2007.




Included
      in the notes receivable at June 30, 2007 are four loans in the amount of
      $8,782,918 for the benefit of a significant shareholder. The majority of these
      loans ($8.16 million) were made during the year ended December 31, 2006 and
      $0.1
      million was made during the six months ended June 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 either of the six months ended June 30, 2007 or
      2006. We accrue related compensation expenses as our options vest in accordance
      with SFAS123(R), *Share-Based
      Payment.* We
      recognized $11,500 and $0 compensation expense during the six months ended
      June
      30, 2007 and 2006, respectively, from the vesting of stock options we issued
      in
      earlier periods.




A
      summary
      of stock option activity during the six months ended June 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
            
            
            -Outstanding
                at June 30, 2007
            
            
            471,250
            
            $
            2.40
            
            $
            4.04
            
            $
            282,750Exercisable
                at June 30, 2007
            
            
            321,250
            
            $
            2.08
            
            $
            1.95
            
            $
            295,550




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





Stock-based
      compensation also includes the value of stock granted to employees and board
      members for services. We recognized stock-based compensation expense of $0
      and
      $15,425 for stock grants for the six months ended June 30, 2007 and 2006,
      respectively.








**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 June 30, 2007 we had $11.15 million in loans of this type.
      The unused or unfunded amount on these types of loans totaled $1.46 million
      as
      of June 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. This
      renewal procedure for the Notes in the absence of the holder’s affirmative
      election had the effect of treating the renewals as automatic when in effect
      the
      holder exchanged the matured Note for a new Note of the same or a similar term.
      During 2007, the Company renewed approximately $5.75 million in principal amount
      of Fixed Term Notes in this manner. The Company believes that these exchanges
      qualified for an exemption under Section 3(a)(9) of the Securities Act of 1933
      (the “Securities Act”). The Company renewed these Notes by providing the holder
      with a form that indicated the maturity of the Note, but did not provide the
      investor with a prospectus nor obtain from the holder a new subscription
      agreement since the Company did not view these renewals as sales of Notes.
      However, the Securities and Exchange Commission (“SEC”) or one or more state
      securities authorities could disagree or otherwise take issue with the reliance
      on the exemption or the manner in which the Company effected these renewals
      and
      could require the Company to offer rescission to holders or take other
      regulatory actions adverse to the Company.





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. Prior to October 19, 2007, per the
      SEC,
      the Company will decide whether to withdraw or amend our Registration Statement
      No. 333-135330 filed with the SEC in August 2006 and amended in November 2006.
      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.
      Subsequent to the close of the second quarter, specifically 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.
      The
      Company was unable to file this Quarterly Report on Form 10-QSB with the SEC
      by
      the extended filing deadline of August 20, 2007, because various operational
      issues delayed work by the registrant’s financial and operational personnel. The
      Company believes that it is in the process of making the necessary changes
      in
      systems and personnel that will resolve these issues.




14


3.
      In
      August 2007 we sold 632,437 of corporate bonds that we held for investment.
      The
      sale resulted in a loss of $52,000.




4.
      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 quarter ended March 31, 2007.  Under the draft order the Company and
      the Company’s Chief Executive Officer Robert L. Harris would (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 period reports and
      certifications of the CEO that are required to be filed with the Securities
      and
      Exchange Commission.  The Company has not yet entered into the proposed
      Consent Order .






**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** **June
      30, 2007 and December 31, 2006**




*Assets* .
      Total
      assets decreased by $4,267,594, from $63,325,701 at December 31, 2006 to
      $59,058,107 at June 30, 2007. The size of our loan portfolio decreased $852,561
      ending at $53,851,459. Cash decreased $3,190,934, from $3,823,013 at December
      31, 2006 to $632,079 at June 30, 2007. The decrease in total assets is primarily
      a result of the expiration of our offering of investor Notes in the second
      quarter of 2006. See "Liquidity and Capital Resources"




*Liabilities* .
      Total
      liabilities decreased by $4,335,442, from  $61,907,387
      at December 31, 2006 to $57,571,945 at June 30, 2007. The net decrease was
      primarily due to a decrease of $12,635,992 in investor Notes, offset by an
      increase of $8,260,766 in other loans payable.




15


*Equity* .
      Total
      stockholders' equity increased by $67,816 from $1,418,314 at December 31, 2006
      to $1,486,162 at June 30, 2007. The increase was due to net income of $156,879
      for the six months ended June 30, 2007, stock-based compensation of $11,500,
      an
      increase of $7,692 in the fair value of marketable investment securities, plus
      $860 in stock sold and, less cash dividend distributions of $109,083 during
      the
      six month period.




*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
      June 30, 2007 we held seven loans that were more than 90 days past due but
      are
      still accruing interest. The total principal and interest due on these loans
      was
      $1,227,785. Five of the loans, totaling $1,173,823, 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 two loans of $53,962 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.




*Non-Accrual
      Loans* .
      As of
      June 30, 2007, there were 13 loans in non-accrual status with an outstanding
      principal balance totaling $520,376. 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 significant loss
      in excess of amounts reserved. We have a specific reserve of $188,495 and a
      general reserve of $231,021 as part of our total reserve of $419,516 for
      anticipated and unanticipated loan losses.




**Comparison
      of Operating Results for** **Six
      Months Ended June 30, 2007 and 2006**




*Net
      interest margin.* The
      average yield earned on loans receivable was 10.55% for the six months ended
      June 30, 2007 and 10.87% for the six months ended June 30, 2006. The average
      rate paid on investor Notes increased to 6.91% for the six months ended June
      30,
      2007 from 6.28% for the six months ended June 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 3.64% for the six months ended
      June 30, 2007, from 4.59 %
      for the
      six months ended June 30, 2006. This net margin is calculated using contractual
      rates and excludes fee income and expense. The current net margin of 3.64%
      is at
      or near its historical low. The Company does not expect any further significant
      decrease.




*Net
      Income* .
      Net
      income for the six months ended June 30, 2007 was $156,879 compared to net
      income of $170,230 for the six months ended June 30, 2006.




*Interest
      Income* .
      Total
      interest income was $3,072,497 for the six months ended June 30, 2007, compared
      to $2,796,514 for the same period in 2006. The additional income resulted
      primarily from an increase in the average interest rate. The interest income
      includes point and fee income and interest earned on bank investments and
      marketable securities.




*Interest
      Expense* .
      Interest expense was $2,154,258 for the six months ended June 30, 2007, and
      $1,837,020 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 $120,000 for the six months ended June 30, 2007,
      compared to $119,272 for the six months ended June 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 income of $23,353 during the six months ended June 30, 2007
      compared to $8,500 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.




*Non-Interest
      Expense* .
      We
      experienced a decrease in non-interest expense to $664,713 for the six months
      ended June 30, 2007 from $678,492 for the six months ended June 30, 2006.
      Increases in salaries and wages and real estate maintenance costs were only
      partially offset by decreases in offering costs and various administration
      costs.




16


*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.






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




*Net
      interest margin.* The
      average yield earned on loans receivable was 10.56% for the three months ended
      June 30, 2007 and 10.54% for the three months ended June 30, 2006. The average
      rate paid on investor Notes increased to 6.76% for the three months ended June
      30, 2007 from 6.07% for the three months ended June 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 3.80% for the three months
      ended June 30, 2007, from 4.47% for the three months ended June 30, 2006. This
      net margin is calculated using contractual rates and excludes fee income and
      expense. The current net margin of 3.80% is at or near its historical low.
      The
      Company does not expect any further significant decrease.




*Net
      Income* .
      Net
      income for the three months ended June 30, 2007 was $72,515 compared to net
      income of $75,096 for the three months ended June 30, 2006.




*Interest
      Income* .
      Total
      interest income was $1,539,952 for the three months ended June 30, 2007,
      compared to $1,485,519 for the same period in 2006. The additional income
      resulted primarily from growth in the average amount of interest-earning assets
      between the two periods, mostly from an increase in loans receivable. The
      interest income includes point and fee income and interest earned on bank
      investments and marketable securities.




*Interest
      Expense* .
      Interest expense was $1,069,941 for the three months ended June 30, 2007, and
      $985,041 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 $75,000 for the three months ended June 30, 2007,
      compared to $61,920 for the three months ended June 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 income of $6,280 during the three months ended June 30, 2007
      compared to a loss of $7,160 for the corresponding period in 2006. The
      difference was primarily due to the more recent period having smaller losses
      on
      the sale of other real estate owned.




*Non-Interest
      Expense* .
      We
      experienced a decrease in non-interest expense to $328,776 for the three months
      ended June 30, 2007 from $356,302 for the three months ended June 30, 2006.
      Increases in salaries and wages and real estate maintenance costs were offset
      by
      decreases in offering costs and various administration costs in the current
      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
      six months ended June 30, 2007, net cash provided by operating activities was
      $1,184,792. The components of this were net income, depreciation, loan losses,
      fixed assets, compensation, and other non-cash charges, and an increase in
      interest payable, totaling $1,598,248, offset by an increase in interest
      receivable, amortization and prepayments of $413,456.





17




For
      the
      six months ended June 30, 2007, net cash provided by investing activities was
      $1,270,193. The expenditures included $6,669,592 for loans made to borrowers
      and
      $46,489 of other purchases and payments. These expenditures were offset by
      principal repayments from borrowers of $7,127,337 and proceeds received from
      the
      sale of real estate and other payments received of $858,937 during the six
      months ended June 30, 2007.




For
      the
      six months ended June 30, 2007, net cash used in financing activities was
      $5,645,919. Proceeds from other loans payable of $23,322,450 and investor notes
      of $1,538,662, together with an increase in unapplied deposits of $30,250,
      sales
      of common stock of $860 and an increase in escrow and security deposits of
      $5,448 were offset by principal payments on investor notes of $15,697,823,
      payments on other loans of $14,736,684, and dividend distributions of
      $109,083.




During
      2007, the Company received money for purchases of its Notes and all such monies
      received have been returned to the sender. 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, would 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.




18


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 June 30, 2007, the Company had cash and cash equivalents of
      $1,221,648, or 2.1% of total assets.






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.
      Prior to October 19, 2007, per the SEC, the Company will decide whether to
      withdraw or amend our Registration Statement No. 333-135330 filed with the
      SEC
      in August 2006 and amended in November 2006. 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
      six years, from 10.6% at December 31, 1999 to 2.5% at June 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 six months ended June 30, 2007 that have materially affected, or
      are
      reasonably likely to materially affect, our internal control over financial
      reporting.




19


**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.




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 quarter ended March 31, 2007.  Under the draft order the Company and
      the Company’s Chief Executive Officer Robert L. Harris would (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 period reports
      and
      certifications of the CEO that are required to be filed with the Securities
      and
      Exchange Commission.  The Company has not yet entered into the proposed
      Consent Order .




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
              10.1
            Copy
                of Promissory Note and Deed of Trust for $2.60 million loan made
                to a
                related party




Exhibit
              10.2
            Copy
                of Promissory Note and Deed of Trust for $0.59 million loan made
                to a
                related party




Exhibit
              10.3
            Copy
                of Promissory Note and Deed of Trust for $2.50 million loan made
                to a
                related party




20




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




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




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




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




(b)
            Reports
                on Form 8-K




None.





21


**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:
                October 3, 2007
            /s/
                William M. BakerWilliam
                M. BakerChief
                Financial Officer




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





22