---



U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



FORM 10-QSB



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



For the quarterly period ended March 31, 2004



Commission File Number 333-106501



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) |  | (IRS Employer Identification Number)



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 ̈



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 March 31, 2004
|Common Stock, $0.01 par value per share |  | 2,485,066                       



Transitional Small Business Disclosure
Format (Check One);



YES ̈NO x



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1



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PART I  FINANCIAL INFORMATION



|ITEM 1. | UNAUDITED FINANCIAL STATEMENTS
|------- | ------------------------------



|                                                         |  | 
|-------------------------------------------------------- |  | 
|                                                         | 
|BALANCE SHEET  PAGE THREE                               |  | 
|                                                         | 
|STATEMENTS OF OPERATIONS  PAGE FOUR                     |  | 
|                                                         | 
|STATEMENTS OF CHANGE IN STOCKHOLDERS EQUITY  PAGE FIVE |  | 
|                                                         | 
|STATEMENTS OF CASH FLOWS  PAGE SIX                      |  | 
|                                                         | 
|NOTES TO INTERIM FINANCIAL INFORMATION  PAGE SEVEN      |  | 



2



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KH FUNDING COMPANY

BALANCE SHEETS



|                                                                                                                                         |  |               |            |   |                  |   |            |  
|---------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ---------- | - | ---------------- | - | ---------- | -
|                                                                                                                                         |  | March 31,2004 |            |   | December 31,2003 |  
|                                                                                                                                         |  | (unaudited)   |            |   |                  |  
|Assets                                                                                                                                   |  |               |            |   |                  |   |            |  
|Notes ReceivableHeld for Yield, Net                                                                                                     |  | $             | 15,219,475 |   |                  | $ | 15,590,526 |  
|Accrued Interest Receivable                                                                                                              |  |               | 540,860    |   |                  |   | 515,495    |  
|Cash                                                                                                                                     |  |               | 1,244,878  |   |                  |   | 1,684,962  |  
|Prepaid Expenses                                                                                                                         |  |               | 398,955    |   |                  |   | 359,121    |  
|Other Receivables                                                                                                                        |  |               | 111,936    |   |                  |   | 1,126,791  |  
|Investments:                                                                                                                             |  |               |            |   |                  |   |            |  
|Marketable Securities                                                                                                                    |  |               | 2,644,764  |   |                  |   | 2,560,104  |  
|Other                                                                                                                                    |  |               | 158,872    |   |                  |   | 191,872    |  
|Property and EquipmentNet                                                                                                               |  |               | 39,858     |   |                  |   | 39,122     |  
|Real Estate Owned:                                                                                                                       |  |               |            |   |                  |   |            |  
|Rental Property                                                                                                                          |  |               | 861,755    |   |                  |   | 863,772    |  
|Held for Resale                                                                                                                          |  |               | 55,267     |   |                  |   | 150,482    |  
|Other Assets                                                                                                                             |  |               | 8,561      |   |                  |   | 8,661      |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Total Assets                                                                                                                             |  | $             | 21,285,181 |   |                  | $ | 23,090,908 |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Liabilities and Stockholders Equity                                                                                                     |  |               |            |   |                  |   |            |  
|Liabilities                                                                                                                              |  |               |            |   |                  |   |            |  
|Notes and Accrued Interest Payable                                                                                                       |  |               | 19,561,396 |   |                  |   | 19,980,673 |  
|Participation Loans                                                                                                                      |  |               | 106,696    |   |                  |   | 105,636    |  
|Borrowings                                                                                                                               |  |               |           |   |                  |   | 1,300,200  |  
|Accounts Payable and Accrued Payroll Liabilities                                                                                         |  |               | 117        |   |                  |   | 2,562      |  
|Escrows and Deposits                                                                                                                     |  |               |           |   |                  |   | 19,924     |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Total Liabilities                                                                                                                        |  |               | 19,668,209 |   |                  |   | 21,408,995 |  
|Stockholders Equity                                                                                                                     |  |               |            |   |                  |   |            |  
|Common Stock (5,000,000 shares authorized; 2,485,066 shares and 2,485,066 shares, respectively, issued and outstanding; $0.01 par
value) |  |               | 24,851     |   |                  |   | 24,851     |  
|Paid-in-Capital                                                                                                                          |  |               | 2,009,874  |   |                  |   | 2,102,765  |  
|Accumulated Deficit                                                                                                                      |  |               | (315,851   | ) |                  |   | (287,900   | )
|Less Subscription and Note Receivable                                                                                                    |  |               | (185,450   | ) |                  |   | (185,450   | )
|Cumulative other Comprehensive Income                                                                                                    |  |               | 83,548     |   |                  |   | 27,647     |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Total Stockholders Equity                                                                                                               |  |               | 1,616,972  |   |                  |   | 1,681,913  |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  
|Total Liabilities and Stockholders Equity                                                                                               |  | $             | 21,285,181 |   |                  | $ | 23,090,908 |  
|                                                                                                                                         |  |               |            |   |                  |   |            |  



The accompanying notes
are an integral part of these statements.



3



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KH FUNDING COMPANY

STATEMENTS OF OPERATIONS



|                                                  |  |                                      |         |   |      |   |        
|------------------------------------------------- |  | ------------------------------------ | ------- | - | ---- | - | -------
|                                                  |  | For the Three Months Ended March 31,
|                                                  |  | 2004                                 |         |   | 2003
|                                                  |  | (unaudited)                         
|Interest Income                                   |  |                                      |         |   |      |   |        
|Interest and Fees on Loans                        |  | $                                    | 458,327 |   |      | $ | 471,179
|Interest on Bank Accounts                         |  |                                      | 571     |   |      |   | 1,740  
|Interest on InvestmentsMarketable Securities     |  |                                      | 30,283  |   |      |   | 11,226 
|Other Interest                                    |  |                                      | 6,084   |   |      |   | 3,245  
|                                                  |  |                                      |         |   |      |   |        
|Total Interest Income                             |  |                                      | 495,265 |   |      |   | 487,390
|Interest Expense                                  |  |                                      |         |   |      |   |        
|Interest and Fees on Borrowing                    |  |                                      | 289,409 |   |      |   | 298,175
|Interest on Participations                        |  |                                      | 3,651   |   |      |   | 20,783 
|                                                  |  |                                      |         |   |      |   |        
|Total Interest Expense                            |  |                                      | 293,060 |   |      |   | 318,958
|                                                  |  |                                      |         |   |      |   |        
|Net Interest Income                               |  |                                      | 202,205 |   |      |   | 168,432
|Provision for Loan Losses                         |  |                                      | 20,000  |   |      |   | 27,000 
|                                                  |  |                                      |         |   |      |   |        
|Net Interest Income after Provision for Loan Loss |  |                                      | 182,205 |   |      |   | 141,432
|Non-interest Income                               |  |                                      |         |   |      |   |        
|Rental Income                                     |  |                                      | 20,054  |   |      |   | 17,588 
|Other                                             |  |                                      | 2,942   |   |      |   | 2,912  
|                                                  |  |                                      |         |   |      |   |        
|Total Non-Interest Income                         |  |                                      | 22,996  |   |      |   | 20,500 
|Non-interest Expense                              |  |                                      |         |   |      |   |        
|Payroll                                           |  |                                      | 64,933  |   |      |   | 59,736 
|Legal and Accounting                              |  |                                      | 30,097  |   |      |   | 11,995 
|Administration                                    |  |                                      | 38,305  |   |      |   | 7,264  
|Loss on Investment                                |  |                                      | 33,000  |   |      |   |       
|Real Estate                                       |  |                                      | 9,373   |   |      |   | 9,443  
|Insurance                                         |  |                                      | 19,933  |   |      |   | 12,081 
|Depreciation                                      |  |                                      | 13,497  |   |      |   | 12,715 
|Rent                                              |  |                                      | 10,659  |   |      |   | 10,158 
|Bank Charges                                      |  |                                      | 5,343   |   |      |   | 5,331  
|Other                                             |  |                                      | 8,012   |   |      |   | 1,095  
|                                                  |  |                                      |         |   |      |   |        
|Total Non-Interest Expense                        |  |                                      | 233,152 |   |      |   | 129,818
|                                                  |  |                                      |         |   |      |   |        
|Net Income (Loss)                                 |  | $                                    | (27,951 | ) |      | $ | 32,114 
|                                                  |  |                                      |         |   |      |   |        



The accompanying notes
are an integral part of these statements.



4



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KH FUNDING COMPANY

STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY



|                                          |  |              |  |                |        |  |                    |           |   |                                 |   |          |                      |  |                          |          |   |  |   |        |  |   |           |  
|----------------------------------------- |  | ------------ |  | -------------- | ------ |  | ------------------ | --------- | - | ------------------------------- | - | -------- | -------------------- |  | ------------------------ | -------- | - |  | - | ------ |  | - | --------- | -
|                                          |  | Common Stock |  | Paid-inCapital |        |  | AccumulatedDeficit |           |   | Subscriptionsand NoteReceivable |   |          | Change inMarketValue |  | TotalStockholdersEquity |         
|                                          |  | Shares       |  | Amount         |        |  |                    |           |  
|Balance at December 31, 2003              |  | 2,485,066    |  |                | 24,851 |  |                    | 2,102,765 |   |                                 |   | (287,900 | )                    |  |                          | (185,450 | ) |  |   | 27,647 |  |   | 1,681,913 |  
|Additional Stock Issued                   |  |             |  |                |       |  |                    |          |   |                                 |   |         |                      |  |                          |         |   |  |   |       |  |   |          |  
|Stock Redeemed                            |  |             |  |                |       |  |                    |          |   |                                 |   |         |                      |  |                          |         |   |  |   |       |  |   |          |  
|Dividend Declared                         |  |             |  |                |       |  |                    | (92,891   | ) |                                 |   |         |                      |  |                          |         |   |  |   |       |  |   | (92,891   | )
|Comprehensive Income:                     |  |              |  |                |        |  |                    |           |   |                                 |   |          |                      |  |                          |          |   |  |   |        |  |   |           |  
|Net Loss for the period                   |  |              |  |                |        |  |                    |           |   |                                 |   | (27,951  | )                    |  |                          |         |   |  |   |       |  |   | (27,951   | )
|Change in Market Value                    |  |              |  |                |        |  |                    |           |   |                                 |   |         |                      |  |                          |         |   |  |   | 55,901 |  |   | 55,901    |  
|                                          |  |              |  |                |        |  |                    |           |   |                                 |   |          |                      |  |                          |          |   |  |   |        |  |   |           |  
|Total Comprehensive Income for the period |  |              |  |                |        |  |                    |           |   |                                 |   |          |                      |  |                          |          |   |  |   |        |  |   | 27,950    |  
|                                          |  |              |  |                |        |  |                    |           |   |                                 |   |          |                      |  |                          |          |   |  |   |        |  |   |           |  
|Balance at March 31, 2004                 |  | 2,485,066    |  | $              | 24,851 |  | $                  | 2,009,874 |   |                                 | $ | (315,851 | )                    |  | $                        | (185,450 | ) |  | $ | 83,548 |  | $ | 1,616,972 |  
|                                          |  |              |  |                |        |  |                    |           |   |                                 |   |          |                      |  |                          |          |   |  |   |        |  |   |           |  



The accompanying notes
are an integral part of these statements.



5



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KH FUNDING COMPANY

STATEMENTS OF CASH FLOWS



|                                                                                        |  |                                      |            |   |      |   |            |  
|--------------------------------------------------------------------------------------- |  | ------------------------------------ | ---------- | - | ---- | - | ---------- | -
|                                                                                        |  | For the Three Months Ended March 31, |           
|                                                                                        |  | 2004                                 |            |   | 2003 |  
|                                                                                        |  | (unaudited)                          |           
|Increase (Decrease) in Cash                                                             |  |                                      |            |   |      |   |            |  
|Cash Flows from Operating Activities                                                    |  |                                      |            |   |      |   |            |  
|Interest Received from Borrowers                                                        |  | $                                    | 431,446    |   |      | $ | 419,201    |  
|Other Receipts                                                                          |  |                                      | 51,075     |   |      |   | 43,641     |  
|Interest Paid on Notes                                                                  |  |                                      | (91,495    | ) |      |   | (157,435   | )
|Paid-for Goods and Services                                                             |  |                                      | (223,511   | ) |      |   | (168,275   | )
|                                                                                        |  |                                      |            |   |      |   |            |  
|Net Cash Provided by Operating Activities                                               |  |                                      | 167,515    |   |      |   | 137,132    |  
|                                                                                        |  |                                      |            |   |      |   |            |  
|Cash Flows from Investing Activities                                                    |  |                                      |            |   |      |   |            |  
|Sale of Real Estate Held for Resale                                                     |  |                                      | 90,795     |   |      |   |           |  
|Principal Repayments from Borrowers                                                     |  |                                      | 1,878,995  |   |      |   | 948,554    |  
|Loans Made to Borrowers                                                                 |  |                                      | (1,519,085 | ) |      |   | (1,559,830 | )
|Purchase of Fixed Assets                                                                |  |                                      | (6,097     | ) |      |   |           |  
|Payments for Other Receivables                                                          |  |                                      |           |   |      |   | (355,193   | )
|Collection of Other Receivable                                                          |  |                                      | 1,014,855  |   |      |   |           |  
|Payments on Other Real Estate Owned                                                     |  |                                      | (1,699     | ) |      |   | (5,444     | )
|Other Assets                                                                            |  |                                      | 100        |   |      |   | (3,257     | )
|Purchase of Marketable Securities and Other Investments                                 |  |                                      | (27,243    | ) |      |   | (484,554   | )
|                                                                                        |  |                                      |            |   |      |   |            |  
|Net Cash Provided By (Used in) Investing Activities                                     |  |                                      | 1,430,621  |   |      |   | (1,459,724 | )
|Cash Flows from Financing Activities                                                    |  |                                      |            |   |      |   |            |  
|Proceeds from Sale of Common Stock                                                      |  |                                      |           |   |      |   | 901        |  
|Proceeds from Investors Notes                                                          |  |                                      | 7,669,795  |   |      |   | 6,080,005  |  
|Increase (Decrease) in Escrow                                                           |  |                                      | (25,547    | ) |      |   | 16,902     |  
|Principal Payments on Investor Notes                                                    |  |                                      | (8,289,414 | ) |      |   | (5,119,985 | )
|Decrease in Participation Loans                                                         |  |                                      | (163       | ) |      |   | (5,397     | )
|Increase (Decrease) in Borrowings                                                       |  |                                      | (1,300,000 | ) |      |   | 194        |  
|Payment of Dividends                                                                    |  |                                      | (92,891    | ) |      |   | (74,532    | )
|                                                                                        |  |                                      |            |   |      |   |            |  
|Net Cash (Used in) Provided by Financing Activities                                     |  |                                      | (2,038,220 | ) |      |   | 898,088    |  
|                                                                                        |  |                                      |            |   |      |   |            |  
|Net Decrease in Cash                                                                    |  |                                      | (440,084   | ) |      |   | (424,504   | )
|Cash Balance, Beginning Of Interim Period                                               |  |                                      | 1,684,962  |   |      |   | 1,574,426  |  
|                                                                                        |  |                                      |            |   |      |   |            |  
|Cash Balance, End Of Interim Period                                                     |  | $                                    | 1,244,878  |   |      | $ | 1,149,922  |  
|                                                                                        |  |                                      |            |   |      |   |            |  
|Reconciliation of Net Income (Loss) to Net Cash from Operating Activities               |  |                                      |            |   |      |   |            |  
|Net Income (Loss)                                                                       |  | $                                    | (27,951    | ) |      | $ | 32,114     |  
|Adjustments to Reconcile Net Income (Loss) to Net Cash provided by Operating Activities |  |                                      |            |   |      |   |            |  
|Depreciation                                                                            |  |                                      | 13,497     |   |      |   | 12,715     |  
|Loss on Investment                                                                      |  |                                      | 33,000     |   |      |   |           |  
|(Increase) Decrease in Prepaid Expenses                                                 |  |                                      | (39,834    | ) |      |   | (23,181    | )
|Loan Loss Reserve Expense                                                               |  |                                      | 20,000     |   |      |   | 27,000     |  
|Increase (Decrease) in Interest Receivable (included in Notes Receivable)               |  |                                      | (26,881    | ) |      |   | (71,490    | )
|Recovery of prior write-off                                                             |  |                                      |           |   |      |   |           |  
|Increase in Interest Payable (included in Notes Payable)                                |  |                                      | 201,565    |   |      |   | 161,523    |  
|(Decrease) Increase in Accounts Payable and Accrued Payroll Liabilities                 |  |                                      | 2,978      |   |      |   | (1,549     | )
|Change in Accrued Late Charges                                                          |  |                                      | 6,441      |   |      |   |           |  
|Amortization of points/fees                                                             |  |                                      | (15,300    | ) |      |   |           |  
|                                                                                        |  |                                      |            |   |      |   |            |  
|Net Cash Provided by Operating Activities                                               |  | $                                    | 167,515    |   |      | $ | 137,132    |  



The accompanying notes
are an integral part of these statements.



6



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KH FUNDING COMPANY

NOTES TO INTERIM UNAUDITED FINANCIAL INFORMATION



NOTE AACCOUNTING POLICIES AND OTHER DATA



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. In the opinion of management the financial statements reflect all the adjustments consisting only of normal recurring accruals necessary for a fair presentation of the results for such periods. 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. You should read these
financial statements in conjunction with the financial statements and the notes thereto included in the Companys annual report on Form 10-KSB at December 31, 2003.



NOTE B



Analysis of the allowance for loan loss is as follows:



|                                         |  |                                    |         |   |             |   |         |  
|---------------------------------------- |  | ---------------------------------- | ------- | - | ----------- | - | ------- | -
|                                         |  | Three Month Period Ended March 31, |        
|                                         |  | 2004                               |         |   | 2003        |  
|                                         |  | (unaudited)                        |         |   | (unaudited) |  
|Beginning balance                        |  | $                                  | 211,000 |   |             | $ | 175,899 |  
|Additions charged to expenses            |  |                                    | 20,000  |   |             |   | 27,000  |  
|Write-off of loans                       |  |                                    | (2,214  | ) |             |   | (1,457  | )
|Recovery of loans previously charged off |  |                                    |        |   |             |   |        |  
|                                         |  |                                    |         |   |             |   |         |  
|                                         |  | $                                  | 228,786 |   |             | $ | 201,442 |  



The following
information is presented as of:



|                                                                                             |  |             |         |          |   |        
|-------------------------------------------------------------------------------------------- |  | ----------- | ------- | -------- | - | -------
|                                                                                             |  | 03/31/04    |         | 12/31/03
|                                                                                             |  | (unaudited) |         |         
|Total recorded investment in impaired loans at the end of the period                         |  | $           | 452,343 |          | $ | 441,474
|Amount of that recorded investment for which there is a related allowance for credit losses  |  | $           | 213,041 |          | $ | 163,631
|Amount of related allowance for credit losses associated with such investment                |  | $           | 175,062 |          | $ | 120,307
|Amount of that recorded investment for which there is no related allowance for credit losses |  | $           | 277,281 |          | $ | 277,843



7



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The following average information is presented for the year and periods ended:



|                                                                                                                  |  |             |         |             |   |          |  |   |        
|----------------------------------------------------------------------------------------------------------------- |  | ----------- | ------- | ----------- | - | -------- |  | - | -------
|                                                                                                                  |  | 03/31/04    |         | 03/31/03    |   | 12/31/03
|                                                                                                                  |  | (unaudited) |         | (unaudited) |   |         
|The average recorded investment in impaired loans during the period.                                              |  | $           | 446,907 |             | $ | 193,395  |  | $ | 308,436
|The related amount of interest income recognized within that period when the loans were impaired.                 |  | $           |        |             | $ |         |  | $ |       
|The amount of income recognized using a cash basis during the time within that period that the loan was impaired. |  | $           |        |             | $ |         |  | $ |       



NOTE CINVESTMENTS



Marketable securities consist of the following at March
31, 2004:



|                                 |  |      |           |        |   |                |  |   |       
|-------------------------------- |  | ---- | --------- | ------ | - | -------------- |  | - | ------
|                                 |  | Cost |           | Market |   | UnrealizedGain
|Corporate Bonds (Net of Premium) |  | $    | 2,445,708 |        | $ | 2,529,256      |  | $ | 83,548
|Money Market Fund                |  |      | 66,620    |        |   | 66,620         |  |   |      
|Accrued Interest-Corporate Bonds |  |      | 48,888    |        |   | 48,888         |  |   |      
|                                 |  |      |           |        |   |                |  |   |       
|                                 |  | $    | 2,561,216 |        | $ | 2,644,764      |  | $ | 83,548



NOTE D-RELATED PARTY TRANSACTIONS



The Company had the following related party transactions
outstanding as shown:



Included in notes receivable are notes
totaling $893,568 and $865,798 as of March 31, 2004 and December 31, 2003, respectively, due 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 notes payable are notes totaling $4,725,804 and $5,508,831 as of March 31, 2004 and December 31, 2003, respectively, which are held by stockholders. These notes were all issued at the rate in effect for
the applicable term selected as of the date the note was issued.



NOTE
E-SUB-S CORPORATE STATUS



During the preparation of the
2003 income tax returns for the company, it was discovered that during 2003 stock in the company was transferred to shareholders who were ineligible to be S corporation shareholders.



The effect of such a transfer is to terminate the S election on the date of the first of these transfers. However, the
Internal Revenue Service has a process by which they will allow the S election to continue based on inadvertent terminations. We believe that the company is eligible for such treatment and will submit a formal request to the Internal
Revenue Service.



8



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|ITEM 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION
|------- | ---------------------------------------------------------



Managements Discussion and Analysis or Plan of Operation and other sections contain forward-looking statements that are based on managements expectations,
estimates, projections and assumptions. Words such as expects, anticipates, plans, believes, estimates and variations of such words and similar expressions are intended to identify such
forward-looking statements that include, but are not limited to, projections of revenues, earnings, segment performance, cash flows and contract awards. 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.



MANAGEMENTS DISCUSSION AND ANALYSIS



Overview



KH Funding Company conducts both
mortgage banking 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 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



Initial Public Offering. On November 3, 2003, our registration statement on Form SB-2 (333- 106501) was declared effective by the U.S.
Securities and Exchange Commission. We registered $30,000,000 of Series 3 Senior Secured Investment Debt Securities and $10,000,000 of Series 4 Subordinated Unsecured Investment Debt Securities. We do not expect any trading market to develop for the
Notes. The offering is not underwritten and the Notes will be sold on a best efforts basis. The Notes will be offered by Mr. Robert L. Harris, our President and Chief Executive Officer, who will not be compensated for such services. In addition, KH
Funding will begin to employ the services of National Association of Securities Dealers, Inc. member broker-dealer(s) for purposes of offering the Notes on a best efforts or agency basis. The offering will terminate one year after the effective date
of the prospectus.



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Comparison of Financial Condition at March 31, 2004 and December 31, 2003



Assets. Total assets decreased $1.80 million, from $23.09 million at
December 31, 2003 to $21.29 million at March 31, 2004. The size of our loan portfolio was mostly unchanged during the period, ending at $15.22 million. Cash decreased approximately $400,000 from January to March and Other Receivables decreased about
$1,000,000 mostly due to the receipt of an amount due from a subscription receivable for stock purchased.



Liabilities. Total liabilities decreased $1.74 million, from $21.41 million at December 31, 2003 to $19.67 million at March 31, 2004. The decrease
was primarily the result of a $1.3 million payoff of short-term borrowing on our margin account.



Equity. Total stockholders equity decreased from $1.68 million at December 31, 2003 to $1.62 million at March 31, 2004. The decrease was due
primarily to the payment of dividends in excess of profits during the period.



Non-accrual Loans. As of March 31, 2004, there were 21 loans not earning interest (non-accrual status) with a book value of $452,342. Approximately half of these loans, or $230,185 are first trust loans that
are well collateralized. In the event we have to foreclose on any of these loans, we do not expect to lose significant sums. The other half of these loans, or $222,157, are second trust loans for which we have a specific reserve established totaling
$175,061.



Delinquent Loans.We sometimes make
hard collateral loans, loans based largely on collateral, where the loan amount is normally 70% or less of the value of the collateral. As of March 31, 2004 we had twenty-three loans on our books that were more than 90 days late but are
still accruing interest. The total amount due on these loans was $2,216,203. Twelve of the loans with a balance of $1,904,494 are hard collateral first trust loans on which we do not expect to lose any significant amount, and the other eleven loans
are paying currently or we anticipate that they will be doing so shortly. For these twenty-three loans we feel justified in continuing to accrue interest because we believe we will be paid in full. These loans are monitored more closely than other
loans in our portfolio.



Comparison of Operating Results for Three Months
Ended March 31, 2004 and 2003



The average yield earned on
loans receivable was 10.79% for the three months ended March 31, 2004 and 10.39% for the three months ended March 31, 2003. The increase was due to an increase in a newer category of loan (purchase, improve and sell loans, i.e., short-term
acquisition and renovation loans) on which we receive significantly higher earnings and fees. The average rate paid on investor accounts declined to 5.60% in the three months ended March 31, 2004 from 6.26% in the three months ended March 31, 2003,
due primarily to rollover by investors of maturing higher interest rate notes. Overall, the net margin on interest increased to 5.19% for the three months ended March 31, 2004, from 4.13% for the three months ended March 31, 2003. The net margin is
computed at note rates and excludes fee income and expense.



Net Income (Loss). Net loss for the three months ended March 31, 2004 was ($27,952), compared to profit of $32,114 for the three months ended March 31, 2003. The major



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contributor to the loss was a write-off of a $33,000 private-equity investment, without which write-off we would have recorded a slight profit for the
quarter.



Interest Income. Total interest income was
$495,265 for the three months ended March 31, 2004, compared to $487,390 for the same period in 2003. The interest income includes point and fee income and interest earned on bank investments and marketable securities.



Interest Expense. Interest expense was $293,060 for the three months
ended March 31, 2004, and $318,958 for the same period in 2003. The decrease resulted from a reduction in loan participations, which are treated as financings, and also to a lowering of the rate we were paying on investor notes. The interest expense
includes fees paid for loan purchases.



Provision for Loan
Losses. We added $20,000 to our provision for loan losses during the three months ended March 31, 2004, compared to $27,000 for the three months ended March 31, 2003. This increased the reserve to an amount deemed by management to be sufficient
to meet all anticipated specific 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 loss of $22,996 during the three months ended March 31, 2004 and $20,500 for the same period in 2003. The
majority of the income in this category is rental income from real estate owned.



Non-Interest (Operating) Expense. We experienced a large increase in non-interest expense to $233,152 for the three months ended March 31, 2004 from $129,818 for the three months ended March 31, 2003. The
majority of the increase of $103,334 was from an increase in costs related to our IPO which was filed with the SEC in November 2003, i.e. $19,000 for additional legal and accounting services during the quarter, $31,000 for administration expense
which includes the amortization expense related to offering costs, and $33,000 on a loss of an investment (private equity).



Income Taxes. KH Funding Company is a Subchapter S corporation under the Internal Revenue code and accordingly no items appear for income taxes.



Liquidity and Capital Resources



KH Funding Companys primary sources of capital are the proceeds from
the sale of securities to investors, principal and interest payments on loans, sales of participation interests in loans and rental income. While maturities and scheduled amortization of loans 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 cause a lot of turnover in our cash positions.



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



|     |  |            |            |                |   |            |  |        |  
|---- |  | ---------- | ---------- | -------------- | - | ---------- |  | ------ | -
|Year |  | Notes Sold |            | Notes Redeemed |   | Percentage | 
|1999 |  | $          | 7,376,780  |                | $ | 5,455,205  |  | 73.95  | %
|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  | %



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. Management believes that 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, the funds for redemption are immediately available. Of course, part of our investment strategy is to invest funds that will be invested with us for a longer period into higher
yielding, slightly less liquid investments, such as bonds; 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. For example, at March 31, 2004 we had outstanding, $1.7 million of one-day demand notes and held $3.9 million in cash and marketable securities and we would have been able to fund redemption requests from available
funds for all one-day demand notes. Only holders of thirty-day demand notes can ask for funds sooner than 90 days, and if necessary, we can sell participation interests in our loans (notes receivables) to have the funds available to meet requests
from these note holders. Only holders of fixed-term notes, prior to maturity, can ask for funds in 90 days, and if necessary, we can sell loans (notes receivables) in bulk to fund requests from these note holders. For example, at December 31, 2003
we held $10,425,739 in first trust residential and commercial property loans that could be sold in part, to a participant bank, or in whole, to other lenders, at or above par value. Further, we held $4,683,148 in business line-of-credit loans and
second trust loans which earn higher yields than the first trust loans and can also be sold, although they generally take longer to sell and are normally sold at a discount. The significance of the company holding these notes that could be sold is
that their value is more than necessary to meet the notes payable maturities for year ended December 31, 2003 of $11,238,569 of 30-day demand and 1-year, 3-year and 5-year fixed notes, under which the investor could request redemption.



We will strive to maintain liquid resources in excess of demand
obligations. This is accomplished by always watching our demand obligations and tailoring our purchase of loans and cash positions according to such obligations.



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Plan to Raise Additional Capital. To date, our Notes have been offered and sold by KH Funding
without the services of an underwriter, broker-dealer or finder. Mr. Robert L. Harris, our President and Chief Executive Officer, has been the only person participating in sales of the offering. However, KH Funding will now begin to employ the
services of National Association of Securities Dealers, Inc. member broker-dealer(s) for purposes of offering the Notes on a best efforts or agency basis. We expect to experience an increase in Note sales from the employ of such broker-dealers. We
intend to use the additional funds to invest in loans and marketable securities.



Known Trends, Events or Uncertainties



Impact of Inflation and Interest Rates. The financial statements of KH Funding 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 KH Funding to its borrowers. Unlike typical industrial companies, nearly all the assets and liabilities of KH Funding 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 11.8% at December 31, 1998 to 7.6% at March 31, 2004. 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 and is a smaller percentage compared to
what it has been in the past, management believes the current ratio is still adequate for noteholders protection. Managements belief is based in part upon the fact that historically we have had loan losses of less than 1% per year, and
the current ratio is more than seven times that amount.



Recent Accounting
Pronouncements



We are evaluating the impact on financial
results, financial condition and cash flows of recently adopted accounting standards that are not yet effective for possible impact on the Company. Such standards include FIN 46R, Consolidation of Variable Interest Entities, which is not
expected to have an impact on the Company.



The preceding paragraphs
discussing the Companys financial condition contain forward-looking statements. The factors affecting the ability of the Company to meet its funding requirements and manage its cash resources include, among other things, the amount and timing
of product sales, inventory turnover, the magnitude of fixed costs, sales growth and the ability to obtain working capital, all of which involve risks and uncertainties that are difficult to predict.



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|ITEM 3. | CONTROLS AND PROCEDURES
|------- | -----------------------



Our Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the design and operation of our disclosure controls and
procedures in accordance with Rule 13a-14 of the Securities Exchange Act of 1934 (the Exchange Act). Based on their evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of the end of the period covered
by this report, our disclosure controls and procedures were effective in enabling us to record, process, summarize and report in a timely manner the information required to be disclosed in reports we file under the Exchange Act.



There were no significant changes in the Companys internal controls or
other factors that could significantly affect internal controls subsequent to the date of the most recent evaluation of such, including any corrective actions with regard to significant deficiencies and material weaknesses.



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PART II  OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------



The Company is not engaged in any material legal proceedings at the present time. From time to time, the Company is a party to legal proceedings within
the normal course of business wherein it enforces its security interest in loans made by it and other matters of a like kind.



|Item 2. | Changes in 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: May 14, 2004 |  |  |  | /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.)



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