##### Table of Contents

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FORM 10-QSB



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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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



For the quarterly period ended September 30, 2005



Commission File Number 333-124155



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KH FUNDING COMPANY

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



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|                                                               |  |                                                          |  |                                     
|-------------------------------------------------------------- |  | -------------------------------------------------------- |  | ------------------------------------
|Maryland                                                       |  | 6162                                                     |  | 52-1886133                          
|(state or other jurisdiction of incorporation or organization) |  | (Primary Standard Industrial Classification Code Number) |  | (IRS Employer Identification Number)



10801 Lockwood
Drive, Suite 370

Silver Spring, Maryland 20901

(301) 592-8100

(address and telephone number of principal executive office)



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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 ̈



Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):    Yes ̈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, 2005
|Common Stock, $0.01 par value per share |  | 2,505,556                           



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



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##### Table of Contents

PART I  FINANCIAL INFORMATION



|                                                                                                                                       |  |          
|-------------------------------------------------------------------------------------------------------------------------------------- |  | ---------
|                                                                                                                                       |  | PAGE NOS.
|ITEM 1. FINANCIAL STATEMENTS                                                                                                           |  |          
|                                                                                                                                       | 
|BALANCE SHEETS  September 30, 2005 (UNAUDITED) and December 31, 2004                                                                  |  | 3        
|                                                                                                                                       | 
|STATEMENTS OF OPERATIONS (UNAUDITED), nine months ended September 30, 2005 and 2004 and three months ended September 30, 2005 and 2004 |  | 4        
|                                                                                                                                       | 
|STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (UNAUDITED), nine months ended September 30, 2005 and 2004                               |  | 5        
|                                                                                                                                       | 
|STATEMENTS OF CASH FLOWS (UNAUDITED), nine months ended September 30, 2005 and 2004                                                    |  | 6        
|                                                                                                                                       | 
|NOTES TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)                                                                                      |  | 7        



2



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##### Table of Contents

KH FUNDING COMPANY

BALANCE SHEETS



|                                                                                                      |  |                   |            |   |                  |   |            |  
|----------------------------------------------------------------------------------------------------- |  | ----------------- | ---------- | - | ---------------- | - | ---------- | -
|                                                                                                      |  | September 30,2005 |            |   | December 31,2004 |  
|                                                                                                      |  | (unaudited)       |            |   |                  |  
|Assets                                                                                                |  |                   |            |   |                  |   |            |  
|Cash                                                                                                  |  | $                 | 6,121,189  |   |                  | $ | 2,669,845  |  
|Investments Available for Sale:                                                                       |  |                   |            |   |                  |   |            |  
|Marketable Securities  at fair value                                                                 |  |                   | 612,629    |   |                  |   | 658,248    |  
|Other                                                                                                 |  |                   | 158,872    |   |                  |   | 158,872    |  
|Loans, Less Allowance for Loan Losses (2005) $272,450 (2004) $233,311                                 |  |                   | 35,865,026 |   |                  |   | 20,144,798 |  
|Accrued Interest Receivable                                                                           |  |                   | 1,121,912  |   |                  |   | 853,448    |  
|Other Receivables                                                                                     |  |                   | 153,239    |   |                  |   | 537,737    |  
|Prepaid Expenses                                                                                      |  |                   | 634,701    |   |                  |   | 445,470    |  
|Property and EquipmentNet                                                                            |  |                   | 58,470     |   |                  |   | 33,755     |  
|Real Estate Owned: Rental Property                                                                    |  |                   | 758,039    |   |                  |   | 709,973    |  
|Other Assets                                                                                          |  |                   | 15,990     |   |                  |   | 9,803      |  
|                                                                                                      |  |                   |            |   |                  |   |            |  
|Total Assets                                                                                          |  | $                 | 45,500,067 |   |                  | $ | 26,221,949 |  
|                                                                                                      |  |                   |            |   |                  |   |            |  
|Liabilities and Stockholders Equity                                                                  |  |                   |            |   |                  |   |            |  
|                                                                                                      |  |                  
|Liabilities                                                                                           |  |                   |            |   |                  |   |            |  
|Notes and Accrued Interest Payable                                                                    |  | $                 | 44,355,488 |   |                  | $ | 24,817,403 |  
|Other Loans Payable                                                                                   |  |                   | 5,694      |   |                  |   | 66,200     |  
|Participation Loans                                                                                   |  |                   | 110,368    |   |                  |   | 107,248    |  
|Accounts Payable and Accrued Payroll Liabilities                                                      |  |                   | 2,544      |   |                  |   | 1,900      |  
|Escrows and Deposits                                                                                  |  |                   | 105,196    |   |                  |   | 33,346     |  
|                                                                                                      |  |                   |            |   |                  |   |            |  
|Total Liabilities                                                                                     |  |                   | 44,579,290 |   |                  |   | 25,026,097 |  
|                                                                                                      |  |                   |            |   |                  |   |            |  
|Stockholders Equity                                                                                  |  |                   |            |   |                  |   |            |  
|Common Stock (5,000,000 shares authorized; 2,505,556 shares, issued and outstanding; $0.01 par value) |  |                   | 25,056     |   |                  |   | 25,056     |  
|Additional Paid-in-Capital                                                                            |  |                   | 1,554,463  |   |                  |   | 1,750,443  |  
|Accumulated Deficit                                                                                   |  |                   | (405,671   | ) |                  |   | (385,373   | )
|Less Subscription Note Receivable                                                                     |  |                   | (185,450   | ) |                  |   | (185,450   | )
|Accumulated Other Comprehensive Loss                                                                  |  |                   | (67,621    | ) |                  |   | (8,824     | )
|                                                                                                      |  |                   |            |   |                  |   |            |  
|Total Stockholders Equity                                                                            |  |                   | 920,777    |   |                  |   | 1,195,852  |  
|                                                                                                      |  |                   |            |   |                  |   |            |  
|Total Liabilities and Stockholders Equity                                                            |  | $                 | 45,500,067 |   |                  | $ | 26,221,949 |  
|                                                                                                      |  |                   |            |   |                  |   |            |  



The accompanying notes
are an integral part of these statements.



3



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##### Table of Contents

KH FUNDING COMPANY

STATEMENTS OF OPERATIONS (UNAUDITED)



|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|--------------------------------------------------- |  | ---------------------------------------- | ------- | - | --------------------------------------- | - | ------- | ---- |  | - | --------- | - |  | - | --------- | -
|                                                    |  | For the Three Months Ended September 30, |         |   | For the Nine Months Ended September 30, |  
|                                                    |  | 2005                                     |         |   | 2004                                    |   |         | 2005 |  |   | 2004      |  
|                                                    |  | (Unaudited)                              |         |   | (Unaudited)                             |  
|Interest Income                                     |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Interest and Fees on Loans                          |  | $                                        | 881,827 |   |                                         | $ | 500,674 |      |  | $ | 2,255,042 |   |  | $ | 1,416,740 |  
|Interest on Bank Accounts                           |  |                                          | 32,281  |   |                                         |   | 29,913  |      |  |   | 74,920    |   |  |   | 90,889    |  
|Interest on Investments Marketable Securities      |  |                                          | 7,708   |   |                                         |   | 837     |      |  |   | 22,422    |   |  |   | 2,550     |  
|Other Interest                                      |  |                                          | 3,469   |   |                                         |   | 3,245   |      |  |   | 52,543    |   |  |   | 32,883    |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Total Interest Income                               |  |                                          | 925,285 |   |                                         |   | 534,669 |      |  |   | 2,404,927 |   |  |   | 1,543,062 |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Interest Expense                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Interest and Fees on Notes Payable                  |  |                                          | 644,936 |   |                                         |   | 319,055 |      |  |   | 1,609,293 |   |  |   | 888,652   |  
|Interest on Participations                          |  |                                          | 3,669   |   |                                         |   | 3,632   |      |  |   | 10,899    |   |  |   | 10,916    |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Total Interest Expense                              |  |                                          | 648,605 |   |                                         |   | 322,687 |      |  |   | 1,620,192 |   |  |   | 899,568   |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Net Interest Income                                 |  |                                          | 276,680 |   |                                         |   | 211,982 |      |  |   | 784,735   |   |  |   | 643,494   |  
|Provision for Loan Losses                           |  |                                          | 39,000  |   |                                         |   | 70,700  |      |  |   | 104,000   |   |  |   | 114,700   |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Net Interest Income after Provision for Loan Losses |  |                                          | 237,680 |   |                                         |   | 141,282 |      |  |   | 680,735   |   |  |   | 528,794   |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Non-interest Income                                 |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Rental Income                                       |  |                                          | 14,030  |   |                                         |   | 17,864  |      |  |   | 46,636    |   |  |   | 54,788    |  
|Loss/Gain on Sale of Real Estate Owned              |  |                                          | (21,694 | ) |                                         |   | 55,615  |      |  |   | (21,694   | ) |  |   | 55,615    |  
|Recognized Loss on Impairment of Securities         |  |                                          |        |   |                                         |   |        |      |  |   |          |   |  |   | (33,000   | )
|Other                                               |  |                                          | 5,671   |   |                                         |   | 2,840   |      |  |   | 16,012    |   |  |   | 8,032     |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Total Non-Interest Income                           |  |                                          | (1,993  | ) |                                         |   | 76,319  |      |  |   | 40,954    |   |  |   | 85,435    |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Non-interest Expense                                |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Salaries and Wages                                  |  |                                          | 88,617  |   |                                         |   | 82,954  |      |  |   | 263,289   |   |  |   | 219,809   |  
|Professional Fees                                   |  |                                          | 36,616  |   |                                         |   | 27,173  |      |  |   | 92,758    |   |  |   | 94,537    |  
|Offering Costs                                      |  |                                          | 52,312  |   |                                         |   | 34,344  |      |  |   | 140,392   |   |  |   | 87,971    |  
|Administration                                      |  |                                          | 26,044  |   |                                         |   | 22,545  |      |  |   | 70,438    |   |  |   | 70,563    |  
|Real Estate Maintenance                             |  |                                          | 4,832   |   |                                         |   | 8,656   |      |  |   | 21,915    |   |  |   | 29,085    |  
|Insurance                                           |  |                                          | 13,454  |   |                                         |   | 13,072  |      |  |   | 47,448    |   |  |   | 50,365    |  
|Depreciation                                        |  |                                          | 12,716  |   |                                         |   | 11,549  |      |  |   | 36,296    |   |  |   | 37,890    |  
|Rent                                                |  |                                          | 11,207  |   |                                         |   | 10,659  |      |  |   | 33,623    |   |  |   | 31,976    |  
|Bank Charges                                        |  |                                          | 5,655   |   |                                         |   | 6,917   |      |  |   | 18,698    |   |  |   | 19,272    |  
|Other                                               |  |                                          | 6,569   |   |                                         |   | 7,192   |      |  |   | 17,130    |   |  |   | 25,127    |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Total Non-Interest Expense                          |  |                                          | 258,022 |   |                                         |   | 225,061 |      |  |   | 741,987   |   |  |   | 666,595   |  
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Net Loss                                            |  | $                                        | (22,335 | ) |                                         | $ | (7,460  | )    |  | $ | (20,298   | ) |  | $ | (52,366   | )
|                                                    |  |                                          |         |   |                                         |   |         |      |  |   |           |   |  |   |           |  
|Basic and diluted loss per share                    |  | $                                        | (0.01   | ) |                                         | $ |        |      |  | $ | (0.01     | ) |  | $ | (0.02     | )
|Cash dividends paid per common share                |  | $                                        | 0.02    |   |                                         | $ | 0.03    |      |  | $ | 0.08      |   |  | $ | 0.11      |  



The accompanying notes
are an integral part of these statements.



4



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##### Table of Contents

KH FUNDING COMPANY

STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (UNAUDITED)

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004



|                                        |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  
|--------------------------------------- |  | ------------ | - |  | -------------- | ------ | - | ------------------ | - | --------- | ------------------------------- |  | - | ------------------------------------------ | - |  | ------------------------ | -------- | - |  | - | ------- | - |  | - | --------- | -
|                                        |  | Common Stock |   |  | Paid-inCapital |        |   | AccumulatedDeficit |   |           | Subscriptionsand NoteReceivable |  |   | AccumulatedOtherComprehensiveIncome (Loss) |   |  | TotalStockholdersEquity |         
|                                        |  | Shares       |   |  | Amount         |        |   |                    |   |           |                                
|Balances at January 1, 2004             |  | 2,485,066    |   |  | $              | 24,851 |   |                    | $ | 2,102,765 |                                 |  | $ | (287,900                                   | ) |  | $                        | (185,450 | ) |  | $ | 27,647  |   |  | $ | 1,681,913 |  
|Additional Stock                        |  | 22,788       |   |  |                | 228    |   |                    |   | 25,833    |                                 |  |   |                                           |   |  |                          |         |   |  |   |        |   |  |   | 26,061    |  
|Stock Redeemed                          |  | (2,298       | ) |  |                | (23    | ) |                    |   | (5,058    | )                               |  |   |                                           |   |  |                          |         |   |  |   |        |   |  |   | (5,081    | )
|Dividend Declared                       |  |             |   |  |                |       |   |                    |   | (279,439  | )                               |  |   |                                           |   |  |                          |         |   |  |   |        |   |  |   | (279,439  | )
|                                        |  |              |   |  |                |        |  
|Comprehensive Income:                   |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Net Loss for the Period                 |  |             |   |  |                |       |   |                    |   |          |                                 |  |   | (52,366                                    | ) |  |                          |         |   |  |   |        |   |  |   | (52,366   | )
|Change in Fair Value of Investments     |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   | 19,013  |   |  |   | 19,013    |  
|                                        |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Total Comprehensive Loss for the Period |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   | (33,353   | )
|                                        |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Balances at September 30, 2004          |  | 2,505,556    |   |  | $              | 25,056 |   |                    | $ | 1,844,101 |                                 |  | $ | (340,266                                   | ) |  | $                        | (185,450 | ) |  | $ | 46,660  |   |  | $ | 1,390,101 |  
|                                        |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Balances at January 1, 2005             |  | 2,505,556    |   |  | $              | 25,056 |   |                    | $ | 1,750,443 |                                 |  | $ | (385,373                                   | ) |  | $                        | (185,450 | ) |  | $ | (8,824  | ) |  | $ | 1,195,852 |  
|Dividend Declared                       |  |             |   |  |                |       |   |                    |   | (195,980  | )                               |  |   |                                           |   |  |                          |         |   |  |   |        |   |  |   | (195,980  | )
|                                        |  |              |   |  |                |        |  
|Comprehensive Income:                   |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Net Loss for the Period                 |  |             |   |  |                |       |   |                    |   |          |                                 |  |   | (20,298                                    | ) |  |                          |         |   |  |   |        |   |  |   | (20,298   | )
|Change in Fair Value of Investments     |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   | (58,797 | ) |  |   | (58,797   | )
|                                        |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Total Comprehensive Loss for the Period |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   | (79,095   | )
|                                        |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  
|Balances at September 30, 2005          |  | 2,505,556    |   |  | $              | 25,056 |   |                    | $ | 1,554,463 |                                 |  | $ | (405,671                                   | ) |  | $                        | (185,450 | ) |  | $ | (67,621 | ) |  | $ | 920,777   |  
|                                        |  |              |   |  |                |        |   |                    |   |           |                                 |  |   |                                            |   |  |                          |          |   |  |   |         |   |  |   |           |  



The accompanying notes
are an integral part of these statements.



5



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##### Table of Contents

KH FUNDING COMPANY

STATEMENTS OF CASH FLOWS (UNAUDITED)



|                                                                        |  |                                         |             |   |             |   |             |  
|----------------------------------------------------------------------- |  | --------------------------------------- | ----------- | - | ----------- | - | ----------- | -
|                                                                        |  | For The Nine Months Ended September 30, |            
|                                                                        |  | 2005                                    |             |   | 2004        |  
|                                                                        |  | (Unaudited)                             |             |   | (Unaudited) |  
|Reconciliation of Net Loss to Net Cash from Operating Activities        |  |                                         |             |   |             |   |             |  
|Net Loss                                                                |  | $                                       | (20,298     | ) |             | $ | (52,366     | )
|Adjustments to Reconcile Net Loss to Net Cash from Operating Activities |  |                                         |             |   |             |   |             |  
|Depreciation                                                            |  |                                         | 36,296      |   |             |   | 37,890      |  
|Increase in Prepaid Expenses                                            |  |                                         | (49,712     | ) |             |   | (78,024     | )
|Provision for Loan Losses                                               |  |                                         | 104,000     |   |             |   | 114,700     |  
|Recovery of Prior Write-off                                             |  |                                         | 6,500       |   |             |   | 4,800       |  
|Increase in Accrued Interest Receivable                                 |  |                                         | (281,642    | ) |             |   | (144,332    | )
|Increase in Accrued Interest Payable (Included in notes payable)        |  |                                         | 934,876     |   |             |   | 508,744     |  
|Loss on Write-down of Investment                                        |  |                                         |            |   |             |   | 33,000      |  
|Increase in Accounts Payable and Accrued interest                       |  |                                         | 644         |   |             |   | 2,180       |  
|Loss (Gain) on Sale of Real Estate Owned                                |  |                                         | 21,694      |   |             |   | (55,615     | )
|Amortization of Loan Fee Income                                         |  |                                         | (33,273     | ) |             |   | (45,300     | )
|Decrease in Accrued Late Charges                                        |  |                                         | 10,227      |   |             |   | 6,562       |  
|Offering Costs                                                          |  |                                         | (140,392    | ) |             |   | (87,971     | )
|                                                                        |  |                                         |             |   |             |   |             |  
|Net Cash Provided by Operating Activities                               |  |                                         | 588,920     |   |             |   | 244,268     |  
|                                                                        |  |                                         |             |   |             |   |             |  
|Cash Flows from Investing Activities                                    |  |                                         |             |   |             |   |             |  
|Principal repayments from borrowers                                     |  |                                         | 12,311,654  |   |             |   | 5,678,576   |  
|Loans made to borrowers                                                 |  |                                         | (28,225,735 | ) |             |   | (8,775,658  | )
|Collections of Other Receivables                                        |  |                                         | 384,498     |   |             |   | 982,469     |  
|Purchase of Marketable Securities and Other Investments                 |  |                                         |            |   |             |   | (102,268    | )
|Payments on Other Real Estate Owned                                     |  |                                         | (30,925     | ) |             |   | (10,155     | )
|Proceeds from Sale of Real Estate Owned                                 |  |                                         | 49,899      |   |             |   | 416,896     |  
|Purchase of Property and Equipment                                      |  |                                         | (42,473     | ) |             |   | (14,237     | )
|Increase in Other Assets                                                |  |                                         | (6,187      | ) |             |   | (1,250      | )
|                                                                        |  |                                         |             |   |             |   |             |  
|Net Cash Used in Investing Activities                                   |  |                                         | (15,559,269 | ) |             |   | (1,825,627  | )
|                                                                        |  |                                         |             |   |             |   |             |  
|Cash Flows from Financing Activities                                    |  |                                         |             |   |             |   |             |  
|Proceeds from Investor Notes                                            |  |                                         | 85,327,830  |   |             |   | 35,201,956  |  
|Principal Payments on Investor Notes                                    |  |                                         | (66,785,127 | ) |             |   | (34,266,658 | )
|Proceeds from Common Stock                                              |  |                                         |            |   |             |   | 26,061      |  
|Collections on Participation Loans                                      |  |                                         | 3,120       |   |             |   | 549         |  
|Payment of Dividends                                                    |  |                                         | (195,980    | ) |             |   | (279,439    | )
|Redemption of Common Stock                                              |  |                                         |            |   |             |   | (5,081      | )
|Increase in Escrows and Deposits                                        |  |                                         | 71,850      |   |             |   | 10,081      |  
|                                                                        |  |                                         |             |   |             |   |             |  
|Net Cash Provided by Financing Activities                               |  |                                         | 18,421,693  |   |             |   | 687,469     |  
|                                                                        |  |                                         |             |   |             |   |             |  
|Net Increase/(Decrease) in Cash                                         |  |                                         | 3,451,344   |   |             |   | (893,890    | )
|Cash Balance, Beginning of Period                                       |  |                                         | 2,669,845   |   |             |   | 1,684,962   |  
|                                                                        |  |                                         |             |   |             |   |             |  
|Cash Balance, End of Period                                             |  | $                                       | 6,121,189   |   |             | $ | 791,072     |  
|                                                                        |  |                                         |             |   |             |   |             |  
|Supplemental Cash Flow Information                                      |  |                                         |             |   |             |   |             |  
|Interest Paid                                                           |  | $                                       | 685,315     |   |             | $ | 390,824     |  
|Transfer of Loans to Other Real Estate Owned                            |  | $                                       | 106,399     |   |             | $ |            |  



The accompanying notes
are an integral part of these statements.



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KH FUNDING COMPANY



NOTES TO
INTERIM FINANCIAL STATEMENTS (UNAUDITED)

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2005 AND 2004



NOTE AACCOUNTING POLICIES AND OTHER DATA



The financial statements for the three and nine month periods ended
September 30, 2005 and 2004 are unaudited and include all adjustments which, in the opinion of management, are necessary to present fairly the results of operations 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 complete financial statements are not included. Operating results for interim periods reflected do not necessarily indicate the results that may be expected for a full fiscal year. These financial statements should be
read in conjunction with the financial statements contained in Form SB-2 of KH Funding Company (the Company) which was filed with the Securities and Exchange Commission and became effective on July 15, 2005 and Form 10-KSB for the
year ended December 31, 2004 filed on April 15, 2005.



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. All of the companys outstanding options are anti-dilutive. As of September 30, 2005 and 2004 the Company had
311,250 and 150,000 options outstanding, respectively.



|                                                   |  |                                          |           |   |                                         |   |           |      |  |   |           |   |  |   |           |  
|-------------------------------------------------- |  | ---------------------------------------- | --------- | - | --------------------------------------- | - | --------- | ---- |  | - | --------- | - |  | - | --------- | -
|                                                   |  | For The Three Months Ended September 30, |           |   | For The Nine Months Ended September 30, |  
|                                                   |  | 2005                                     |           |   | 2004                                    |   |           | 2005 |  |   | 2004      |  
|                                                   |  | (Unaudited)                              |           |   | (Unaudited)                             |  
|Basic:                                             |  |                                          |           |   |                                         |   |           |      |  |   |           |   |  |   |           |  
|Net Loss                                           |  | $                                        | (22,334   | ) |                                         | $ | (7,460    | )    |  | $ | (20,298   | ) |  | $ | (52,366   | )
|Weighted Average Common Shares Outstanding         |  |                                          | 2,505,556 |   |                                         |   | 2,505,556 |      |  |   | 2,505,556 |   |  |   | 2,492,333 |  
|Basic Earnings Per Share                           |  | $                                        | (0.01     | ) |                                         | $ |          |      |  | $ | (0.01     | ) |  | $ | (0.02     | )
|                                                   |  |                                          |           |  
|Diluted:                                           |  |                                          |           |   |                                         |   |           |      |  |   |           |   |  |   |           |  
|Net Loss                                           |  | $                                        | (22,334   | ) |                                         | $ | (7,460    | )    |  | $ | (20,298   | ) |  | $ | (52,366   | )
|Weighted Average Common Shares Outstanding         |  |                                          | 2,505,556 |   |                                         |   | 2,505,556 |      |  |   | 2,505,556 |   |  |   | 2,492,333 |  
|Dilutive Effect of Stock Options                   |  |                                          |          |   |                                         |   |          |      |  |   |          |   |  |   |          |  
|                                                   |  |                                          |           |   |                                         |   |           |      |  |   |           |   |  |   |           |  
|Weighted Average Common Shares Outstanding-Diluted |  |                                          | 2,505,556 |   |                                         |   | 2,505,556 |      |  |   | 2,505,556 |   |  |   | 2,492,333 |  
|                                                   |  |                                          |           |   |                                         |   |           |      |  |   |           |   |  |   |           |  
|Diluted Earnings Per Share                         |  | $                                        | (0.01     | ) |                                         | $ |          |      |  | $ | (0.01     | ) |  | $ | (0.02     | )



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.



Nature of Operation



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



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##### Table of Contents

KH FUNDING COMPANY



NOTES TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)



New Accounting Pronouncements



In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No.123R
Share-Based Paymentwhich replaces SFAS No. 123 Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25 Accounting for Stock Issued to Employees. SFAS No. 123R requires all share-based payments
to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values and provides that the pro forma disclosures previously permitted under SFAS No. 123 no longer will be an
alternative to financial statement recognition. The original effective date for SFAS No. 123R was the first interim or annual period after June 15, 2005, with early adoption encouraged. On April 21, 2005, the Securities and Exchange
Commission amended Rule 4-01(a) under Regulation S-X to provide that each registrant that is a small business issuer is required to comply with SFAS No. 123R beginning with the first annual or interim reporting period of the registrants
first fiscal year beginning on or after December 15, 2005. In the Companys case, this means that compliance is required beginning in the first quarter of fiscal year 2006.



The pro forma disclosures previously permitted under SFAS No. 123 no longer will be an alternative to financial
statement recognition. Under SFAS No. 123R, the Company must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of
adoption. The transition methods include prospective and retroactive adoption options. The Company is evaluating the requirements of SFAS No. 123R. However, the Company expects that the adoption of SFAS No. 123R will not have a material
impact on its results of operations and earnings per share. The Company has not yet determined the method of adoption or the effect of adopting SFAS No. 123R, and it has not determined whether the adoption will result in amounts that are
similar to the current pro forma disclosures under SFAS No. 123. The Company also has not yet determined the impact of SFAS No. 123R, if any, on its compensation policies or plans.



Stock Based Compensation



The Company has adopted the disclosure-only provisions of Statements of
Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-based Compensation and related interpretations in accounting for its stock compensation plan. No compensation expense related to stock options was recorded during the
nine or three month periods ended September 30, 2005 and 2004. If the Company had elected to recognize compensation cost based on fair value at the vesting dates for awards under the plan consistent with the method prescribed by SFAS
No. 123, net income and earnings per share would not have changed because no stock options were granted or were being earned in the nine month periods ending September 30, 2005 and 2004. As is discussed above, beginning January 1,
2006 the Company will comply with SFAS No.123R.



NOTE B IMPAIRED LOANS
AND ALLOWANCE FOR LOAN LOSSES



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 loans principal balance. Interest income on the other nonaccrual loans is recognized only to the
extent of interest payments received.



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##### Table of Contents

KH FUNDING COMPANY



NOTES TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)



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



|                                                                                                                  |  |                                 |            |   |                    |   |            |  
|----------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | ---------- | - | ------------------ | - | ---------- | -
|                                                                                                                  |  | September 30,2005               |            |   | December 31,2004   |  
|Impaired loans with specific allowance                                                                            |  | $                               | 784,988    |   |                    | $ | 516,126    |  
|Impaired loans without specific allowance                                                                         |  |                                 | 48,053     |   |                    |   | 67,225     |  
|                                                                                                                  |  |                                 |            |   |                    |   |            |  
|Total impaired loans                                                                                              |  |                                 | 833,041    |   |                    | $ | 583,351    |  
|                                                                                                                  |  |                                 |            |   |                    |   |            |  
|Allowance for loan losses applicable to impaired loans                                                            |  | $                               | 225,444    |   |                    | $ | 175,117    |  
|Allowance for loan losses applicable to other than impaired loans                                                 |  |                                 | 47,006     |   |                    |   | 58,194     |  
|                                                                                                                  |  |                                 |            |   |                    |   |            |  
|Total allowance for loan losses                                                                                   |  |                                 | 272,450    |   |                    | $ | 233,311    |  
|                                                                                                                  |  |                                 |            |   |                    |   |            |  
|                                                                                                                  |  |                                
|                                                                                                                  |  | September 30, 2004              |            |   | September 30, 2005 |  
|Amount of interest income recognized within nine month period when the loans were impaired                        |  | $                               |           |   |                    | $ |           |  
|Amount of interest income recognized using a cash basis during the nine month period when the loans were impaired |  | $                               |           |   |                    | $ |           |  
|                                                                                                                  |  |                                
|Analysis of the allowance for loan losses is as follows:                                                          |  |                                 |            |   |                    |   |            |  
|                                                                                                                  |  | Nine Months Ended September 30, |           
|                                                                                                                  |  | 2005                            |            |   | 2004               |  
|                                                                                                                  |  |                                 | (unaudited | ) |                    |   | (unaudited | )
|Beginning balance                                                                                                 |  | $                               | 233,311    |   |                    | $ | 211,000    |  
|Additions charged to expenses                                                                                     |  |                                 | 104,000    |   |                    |   | 114,700    |  
|Write-off of loans                                                                                                |  |                                 | (71,361    | ) |                    |   | (130,179   | )
|Recovery of loans previously charged off                                                                          |  |                                 | 6,500      |   |                    |   | 4,800      |  
|                                                                                                                  |  |                                 |            |   |                    |   |            |  
|Balance at end of period                                                                                          |  | $                               | 272,450    |   |                    | $ | 200,321    |  
|                                                                                                                  |  |                                 |            |   |                    |   |            |  



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KH FUNDING COMPANY



NOTES TO INTERIM FINANCIAL STATEMENTS (UNAUDITED)



NOTE CINVESTMENTS



Marketable securities consists of the following at the periods indicated:



|                                 |  |                    |         |            |   |                |  |   |         |  
|-------------------------------- |  | ------------------ | ------- | ---------- | - | -------------- |  | - | ------- | -
|                                 |  | September 30, 2005 |        
|                                 |  | Amortized Cost     |         | Fair Value |   | UnrealizedLoss | 
|Corporate Bonds (Net of Premium) |  | $                  | 625,383 |            | $ | 557,762        |  | $ | (67,621 | )
|Money Market Fund                |  |                    | 54,867  |            |   | 54,867         |  |   |        |  
|                                 |  |                    |         |            |   |                |  |   |         |  
|                                 |  | $                  | 680,250 |            | $ | 612,629        |  | $ | (67,621 | )
|                                 |  |                    |         |            |   |                |  |   |         |  
|                                 | 
|                                 |  | December 31, 2004  |        
|                                 |  | Amortized Cost     |         | Fair Value |   | UnrealizedLoss | 
|Corporate Bonds (Net of Premium) |  | $                  | 632,211 |            | $ | 623,387        |  | $ | (8,824  | )
|Money Market Fund                |  |                    | 34,861  |            |   | 34,861         |  |   |        |  
|                                 |  |                    |         |            |   |                |  |   |         |  
|                                 |  | $                  | 667,072 |            | $ | 658,248        |  | $ | (8,824  | )
|                                 |  |                    |         |            |   |                |  |   |         |  



Other investments
available for sale of $158,872 at September 30, 2005 and December 31, 2004 consists of equity investment in private companies. The costs of these non-marketable securities approximates their fair value.



NOTE DRELATED PARTY TRANSACTIONS



The Company engaged in the following related party transactions:



Included in notes receivable at December 31, 2004, are 6 notes
totaling $1,833,611 and as of September 30, 2005 are 13 notes totaling $6,273,822 from officers, stockholders and a company controlled by an officer. These notes all have annual maturities and are due in full on the maturity date unless
extended by the Company. The interest rates on these notes range between 5.99% and 12.5%.



Included in the notes payable balance at December 31, 2004, are 58 notes totaling $5,443,947, and as of September 30, 2005 are 60 notes totaling $6,074,452 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.



There is a note receivable included in other receivables of $185,450, shown on the balance sheet at September 30, 2005 and December 31, 2004 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. Accrued interest receivable on this loan totals $73,025 and $69,780 at September 30,
2005 and December 31, 2004, respectively.



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##### Table of Contents

KH FUNDING COMPANY



NOTES TO INTERIM UNAUDITED FINANCIAL STATEMENTS (UNAUDITED)



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 Investment Debt Securities payable on demand by the holders, delinquencies in our loan portfolio, 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



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



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



Recent Developments



On July 15, 2005, our registration statement on Form SB-2 (333-124155)
was declared effective by the U.S. Securities and Exchange Commission. We registered $120,000,000 of Series 3 Senior Secured Investment Debt Securities and $30,000,000 of Series 4 Subordinated Unsecured Investment Debt Securities. The offering is
not underwritten and the Notes are being sold on a best efforts basis by Mr. Robert L. Harris, who is not compensated for such services, and by Capital Financial Services and Spencer Edwards Inc., NASD member broker-dealers, who are
compensated for their services.



Critical Accounting Policies



Our significant accounting policies are disclosed in the footnotes to the
financial statements included in Form 10-KSB. 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



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##### Table of Contents

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, 2005 and December 31, 2004



Assets. Total assets increased $19.28 million, from $26.22 million at
December 31, 2004 to $45.50 million at September 30, 2005. The size of our loan portfolio increased $15.72 million ending at $35.87 million. Cash increased $3.45 million, from $2.67 million at December 31, 2004 to $6.12 million at
September 30, 2005. The increase in total assets is primarily a result of the receipt of funds from our continuing offering of investor notes. See Liquidity and Capital Resources



Liabilities. Total liabilities increased $19.55 million, from $25.03
million at December 31, 2004 to $44.58 million at September 30, 2005. The increase was mostly due to an increase of $19.54 million in notes payable to investors.



Equity. Total stockholders equity decreased from $1.2 million at December 31, 2004 to $.92 million at
September 30, 2005. The decrease was due to the payment of dividends, a net loss, and a decrease in the fair value of marketable investment securities.



Past Due Loans.We generally make hard collateral loans, based largely on collateral value or, where the loan amount is below 70% of
the collateral value. As of September 30, 2005 we had 17 loans on our books that were more than 90 days past due but are still accruing interest. The total amount due on these loans was $1,958,208. Eight of the loans, totaling $770,843, are
first trust real estate loans on which we do not expect to suffer any loss due to collateral value, and the other nine loans are paying currently or we anticipate that they will be doing so shortly. We continue to accrue interest on these loans
based on the underlying collateral value and payment history. We monitor these loans on a consistent basis.



Non-accrual Loans. As of September 30, 2005, there were 21 loans in non-accrual status with a value of $833,041. The majority of these loans
are first trust loans that are well collateralized. In the event we have to foreclose on any of these loans, we do not expect any significant loss. We have a specific reserve of $225,444 and a general reserve of $47,006 as part of our total reserve
of $272,450 for anticipated and unanticipated loan losses.



Comparison of
Operating Results for Three Months Ended September 30, 2005 and 2004



The average yield earned on loans receivable was 10.46% for the three months ended September 30, 2005 and 10.53% for the three months ended September 30, 2004. The average rate paid on investor accounts
increased to 6.08% for the three months ended September 30, 2005 up from 5.77% for the three months ended September 30, 2004, due primarily to an increase in the rate we are paying on investor notes. Overall, the net margin on interest
decreased to 4.38% for the three months ended September 30, 2005, from 4.76% for the three months ended September 30, 2004. This net margin is calculated using note rates and excludes fee income and expense.



Net Loss. Net loss for the three months ended September 30, 2005
was $22,335 compared to a loss of $7,460 for the three months ended September 30, 2004.



Interest Income. Total interest income was $925,285 for the three months ended September 30, 2005, compared to $534,669 for the same period in 2004. 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 $648,605 for the three months
ended September 30, 2005, and $322,687 for the same period in 2004. The additional expense resulted primarily from an increase in investor accounts. The interest expense includes the amortization of fees paid to Brokers-Dealers for the sale of
investor notes and interest paid on participation loans.



Provision for Loan Losses. Our provision for loan losses was $39,000 for the three months ended September 30, 2005, compared to $70,700 for the three months ended September 30, 2004. These provisions increased the allowance
for loan losses after write-offs 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.



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Non-Interest Income. We had non-interest income of $(1,993) during the three months ended
September 30, 2005 compared to $76,319 for the same period in 2004. The difference was due to a gain from the sale of real estate owned in 2004.



Non-Interest Expense. We experienced an increase in non-interest expense to $258,022 for the three months ended September 30, 2005 from
$225,061 for the three months ended September 30, 2004. The majority of the increase was for salaries and wages, offering costs and 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 appear in the financial statements.



Comparison of
Operating Results for Nine Months Ended September 30, 2005 and 2004



The average yield earned on loans receivable was 10.62% for the nine months ended September 30, 2005 and 10.59% for the nine months ended September 30, 2004. The average rate paid on investor accounts
increased to 6.00% for the nine months ended September 30, 2005 from 5.65% for the nine months ended September 30, 2004, due primarily to an increase in the rate we are paying on investor notes. Overall, the net margin on interest
decreased to 4.62% for the nine months ended September 30, 2005, from 4.94% for the nine months ended September 30, 2004. This net margin is calculated using note rates and excludes fee income and expense.



Net Loss. The Companys net loss for the nine months ended
September 30, 2005 was $20,298, compared to a loss of $52,366 for the nine months ended September 30, 2004.



Interest Income. Total interest income was $2.4 million for the nine months ended September 30, 2005, compared to $1.5 million for the same
period in 2004. 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 points and fee income and
interest earned on bank investments and marketable securities.



Interest Expense. Interest expense was $1,620,192 for the nine months ended September 30, 2005, and $899,568 for the same period in 2004. The additional expense resulted primarily from an increase in investor accounts. The
interest expense includes the amortization of fees paid to Brokers-Dealers for the sale of investor notes.



Provision for Loan Losses. Our provision for loan losses was $104,000 for the nine months ended September 30, 2005, compared to $114,700 for
the nine months ended September 30, 2004. These provisions increased the allowance for loan losses after write-offs 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 $40,954 during the nine months ended September 30, 2005 compared to $85,435 for the same period in 2004. The majority of the non-interest income is rental income from real estate owned. There was a loss on the sale of real estate
owned in 2005 of $21,694 and a gain in 2004 of $55,615.



Non-Interest Expense. We experienced an increase in non-interest expense to $741,987 for the nine months ended September 30, 2005 from $666,595 for the nine months ended September 30, 2004. The majority of the increase was
for salaries and wages and offering 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 appear in the financial statements.



Liquidity and Capital Resources



KH Funding Companys primary sources of funding are the proceeds from
the sale of notes payable to investors, principal and interest payments on loans receivable, sale of loans and rental income. 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 demand notes payable can cause volatility in our cash balances.



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The table below illustrates the Sales of Notes Payable versus Redemptions for the years indicated:



|                                     |  |            |            |               |   |            |  |        |  
|------------------------------------ |  | ---------- | ---------- | ------------- | - | ---------- |  | ------ | -
|Year                                 |  | Notes Sold |            | NotesRedeemed |   | Percentage | 
|2000                                 |  | $          | 10,367,351 |               | $ | 10,661,308 |  | 102.84 | %
|2001                                 |  | $          | 14,418,456 |               | $ | 11,280,177 |  | 78.23  | %
|2002                                 |  | $          | 22,926,619 |               | $ | 18,681,654 |  | 81.47  | %
|2003                                 |  | $          | 26,630,166 |               | $ | 24,697,776 |  | 92.74  | %
|2004                                 |  | $          | 49,008,102 |               | $ | 44,786,895 |  | 91.39  | %
|Nine Months Ended September 30, 2005 |  | $          | 85,327,830 |               | $ | 66,785,127 |  | 78.27  | %



During the past few
years, the combination of generally low interest rates on deposit products at commercial banks, the poor performance of the stock market and increasing referrals from customers have positioned KH Funding to experience solid growth in the number of
new investors attracted to its investment products. Based on its monitoring of historic trends and its current pricing strategy for investor accounts, management believes KH Funding Company will retain a large portion of its existing investors and
will experience a significant increase of funds from new investors in the future.



Redemption of Notes Payable. The risk of not being able to fund redemption requests only exists if the requests for redemption exceed the amount of readily available cash, i.e., if our liquidity is insufficient
to fund redemptions. Upon the sale of a note payable, the funds for redemption are immediately available. Of course, part of our investment strategy is to place funds that are invested with us for a longer period into higher yielding, less liquid
investments, such as mortgages; nevertheless, the funds are still available, just not immediately. Only holders of one-day demand notes can ask for funds sooner than thirty days, and we make an effort to keep funds available for these requests. Only
holders of thirty-day demand notes can ask for funds sooner than 90 days, and if the funds will not be available within thirty days, we will sell some of our mortgage loans (notes receivables) 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 will sell loans (notes
receivables) in bulk to fund redemption requests from note holders.



The Company strives to maintain sufficient liquidity to meet all redemption requests. We normally hold 10% to 20% of our assets in cash and cash equivalents to fund redemptions of one-day accounts. This amount has historically been
sufficient for us to meet our obligations. Also, if required, we are able to sell loans within 30 days to raise cash to meet redemption requests from 30-day account holders or within 90 days to meet early redemption requests from term account note
holders.



Plan to Raise Additional Capital. We plan to
continue with our ongoing public offering of investor notes. However, there is no assurance that such offering will be successful.



We have been able to attract more investors who are interested in our longer-term fixed rate notes. Since February 2003, we have been offering trust
services for IRA accounts through our Trust Services Department. We intend to expand these services and believe that IRA investors generally look for investments of a long-term nature, which complements our preferred mode of investing.



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 five years, from 10.6% at December 31, 1999 to 2.0% at September 30, 2005. 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 dividend distributions to be equal to or less than the net income in order to inhibit further decreases in stockholder equity.



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ITEM 3. CONTROLS AND PROCEDURES



Based on their most recent evaluation, which was completed within 90 days of the filing of this Form 10-QSB, Robert L.
Harris, the Companys Chief Executive Officer and Louise B. Sehman, the Companys Chief Financial Officer, have concluded that the Companys disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) are
effective to ensure that information required to be disclosed by the Company in this report is accumulated and communicated to the Companys management, including its principal executive officer and principal financial officer, as appropriate,
to be recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commissions rules and forms.



There were no changes in the Companys internal controls or other factors that could significantly affect these controls subsequent to the date of
their evaluation and there were no corrective actions with regard to significant deficiencies and material weaknesses.



PART II  OTHER INFORMATION



Item 1. Legal Proceedings



On September 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 the Company. SBM claims that we have intentionally interfered with the ability of SBM to retain their existing investors. We believe that their claim is groundless. At present,
we expect no material impact to KH Funding as a result of this litigation.



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
| | --- | -------------------



None



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SIGNATURE



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



|                        |  |                                                 
|----------------------- |  | ------------------------------------------------
|                        |  | KH FUNDING COMPANY                              
|                        |  | (Registrant)                                    
|                        | 
|Date: November 14, 2005 |  |                                                 
|                        | 
|                        |  | /s/ Louise B. Sehman                            
|                        |  | Louise B. Sehman                                
|                        |  | Chief Financial Officer, Secretary and Treasurer



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



16