**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**





**FORM
      10-KSB**





**ANNUAL
      REPORT PURSUANT TO SECTION 13 OR 15(d)**


**OF
      THE SECURITIES EXCHANGE ACT OF 1934**





**For
      the fiscal year ended December 31, 2007**





**Commission
      File No. 333-106501**





**KH
      FUNDING COMPANY**


(Name
      of
      small business issuer in its charter)





**Maryland**
            **52-1886133**(State
                or other jurisdiction of
              incorporation
                or organization)
            (I.R.S.
                Employer
              Identification
                No.)





**10801
      Lockwood Drive, Suite 370**


**Silver
      Spring, Maryland 20901**


Address
      of principal executive offices, including zip code





**(301)
      592-8100**


Registrant’s
      telephone number, including area code







Securities
                registered under Section 12(b) of the Act:**None**Securities
                registered under Section 12(g) of the Act:**None**









Check
      whether the issuer is not required to file reports pursuant to Section 13 or
      15(d) of the Exchange Act.


Yes  ̈ No x




Check
      whether the issuer (1) filed all reports required to be filed by Section 13
      or
      15(d) of the Exchange Act 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  ̈




Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B contained in this form, and no disclosure will be contained,
      to
      the best of Registrant’s knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-KSB or any
      amendment to this Form 10-KSB. 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




Registrant’s
      revenues for its most recent fiscal year were: **$6,117,128** .




There
      is
      no established market for the registrant’s common equity. Based on the last sale
      price of the registrant’s common stock known to the registrant ($2.00 per share
      on August 16, 2007), the aggregate market value of the voting and non-voting
      common equity held by non-affiliates is $5,449,968.





As
      of
      March 31, 2008, there were 2,574,981 outstanding shares of the registrant’s
      common stock.







**PART
      I**




This
      Annual Report of KH Funding Company on Form 10-KSB contains forward-looking
      statements within the meaning of The Private Securities Litigation Reform Act
      of
      1995. Readers of this report should be aware of the speculative nature of
“forward-looking statements.” Statements that are not historical in nature,
      including the words “anticipate”, “estimate”, “should”, “expect”, “believe”,
“intend”, and similar expressions, are based on current expectations, estimates
      and projections about (among other things) the industry and the markets in
      which
      KH Funding Company operates; they are not guarantees of future performance.
      Whether actual results will conform to expectations and predictions is subject
      to known and unknown risks and uncertainties, including risks and uncertainties
      discussed in this Form 10-KSB, general economic, market or business conditions;
      changes in interest rates, the cost of funds, and demand for loan products
      and
      services; changes in our competitive position or competitive actions by other
      companies; changes in the quality or composition of loan and investment
      portfolios; the ability to mange growth; changes in laws or regulations or
      policies of federal and state regulators and agencies; and other circumstances
      beyond our control. Consequently, all of the forward-looking statements made
      in
      this document are qualified by these cautionary statements, and there can be
      no
      assurance that the actual results anticipated will be realized, or if
      substantially realized, will have the expected consequences on our business
      or
      operations. For a more complete discussion of these and other risk factors,
      see
      Item 1 of Part I under the heading “Risk Factors”. Except as required by
      applicable laws, we do not intend to publish updates or revisions of
      forward-looking statements we make to reflect new information, future events
      or
      otherwise.





As
      used
      in this annual report, the terms “Company”, “KH Funding” and “we”, “our”, and
“us” refer to KH Funding Company.





**ITEM
      1.**  **DESCRIPTION
      OF BUSINESS**




**General**




KH
      Funding conducts mortgage banking operations from its headquarters in Silver
      Spring, Maryland. Our primary business activities consist of originating,
      acquiring and servicing mortgage and business loans. We emphasize the direct
      origination of small commercial real estate mortgage loans and investment
      property residential mortgage loans. We also purchase first and second mortgage
      loans secured by residential real estate from other lenders and banks around
      the
      country. To fund our operations, we rely on interest income generated from
      our
      lending and investment activities and from proceeds from sales of interest
      bearing debt securities to investors (“investor notes”),





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




**Operations**





We
      operate from a suite of offices located in Silver Spring, Maryland. We act
      as a
      mortgage banker or purchaser of mortgage and business loans and perform the
      record keeping, loan administration and servicing functions with regard to
      our
      assets and liabilities. For example, our mortgage loan servicing includes
      collecting payments, paying property taxes and insurance, and if necessary,
      instituting foreclosure procedures. We also administer our program of selling
      fixed and variable rate debt securities of varying maturities. In addition,
      in
      February 2003 we were approved by the Internal Revenue Service as a retirement
      account trustee. We accept and administer purchases of our investor notes for
      IRA and SEP accounts. Currently, these services are provided by KH Funding
      personnel that have other responsibilities; however, we intend to expand these
      trust services in the future.





Our
      assets of $53.39 million at December 31, 2007 consist primarily of cash,
      mortgage loans, real property and investment securities. In the normal course
      of
      business we collect the income generated by the assets; receive funds from
      investors; handle the redemption of investor notes; and maintain and track
      the
      receipts, disbursements and balances on escrow accounts established by our
      borrowers.





The
      following table sets forth certain information relating to our net interest
      spread for the five years ended December 31, 2007. The average yield and cost
      of
      funds are derived by dividing interest income or interest expense by the average
      balance (exclusive of nonaccrual loans and of unamortized fees and costs) of
      loans receivable or investor notes, respectively, for the years shown. The
      interest categories are at contract rates and exclude the amortization of
      related fee income and expense.





2





**Year**
            
            **Average
                Yield****Loan
                Portfolio**
            
            **Cost
                of Funds****Investor
                Notes**
            
            **Net
                Interest****Rate
                Spread**2003
            
            
            10.74
            %
            
            6.00
            %
            
            4.74
            %2004
            
            
            10.89
            %
            
            5.69
            %
            
            5.20
            %2005
            
            
            10.66
            %
            
            6.03
            %
            
            4.63
            %2006
            
            
            11.05
            %
            
            6.53
            %
            
            4.52
            %2007
            
            
            10.65
            %
            
            7.09
            %
            
            3.56
            %




**Technology**





We
      maintain an off-site secondary location which has full back-up operability
      with
      up-to-date information. The software we use to track our loan portfolio is
      used
      commercially by over 300 other subscribers. Our investment account software
      was
      made to our specifications to allow us to service the holders of our investor
      notes in an efficient and timely manner.




**Customer
      Service**





We
      provide monthly statements and timely, personal service to our investors, which
      have always cultivated a good “word-of-mouth” referral system. We have developed
      and made available to our investors on-line access to their accounts at our
      Internet website, www.khfunding.com .
      The
      website allows investors to view their account information at anytime, such
      as
      account balances, maturity dates and recent transactions. Access to the website
      allows investors to complete transfers from one account to another account,
      order wire transfers, and request withdrawals.




**Business
      Strategy**





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





Starting
      in the fourth quarter of 2004, we expanded the distribution for our investor
      notes by engaging in strategic alliances with several major financial services
      firms throughout the country. We currently have signed selling agreements with
      three NASD registered broker-dealers with a network of over 1,200 registered
      representatives in the Midwest and West. These alliances have given us the
      ability to sell our investor notes through a network of financial intermediaries
      in defined geographic locations. To date, our distribution plan has been very
      successful, establishing close to 700 new investment accounts providing us
      with
      over $25,000,000 in funds. In 2006, sales by these broker-dealers established
      approximately 522 new investment accounts and provided over $11 million in
      funds. We plan to further increase our distribution network, and are currently
      in negotiations with other NASD member broker-dealers interested in distributing
      our investor notes in parts of the United States where we are not currently
      represented.





Our
      business strategy has been hampered during the past two fiscal years because
      we
      have not been able to sell our investor notes in our principal markets. In
      June
      2006, we filed a registration statement with the Securities and Exchange
      Commission (the “SEC”) and with several state securities regulators, including
      the Division of Securities of the Office of the Maryland Attorney General (the
      “Maryland Securities Division”), to register the sale of up to $250,000,000 of
      our investor notes. Although the SEC and several state securities regulators
      declared this registration statement effective, the Maryland Securities Division
      did not. On January 23, 2008, we filed an amended registration statement to
      update certain information and to renew the registration process. Again,
      although the SEC and several state securities regulators declared the amended
      registration statement effective, we are still working with the Maryland
      Securities Division to have it declared effective in Maryland. In
      2008,
      the Maryland Securities Division informed us that it is investigating a former
      employee who allegedly misappropriated funds of an investor between 2004 and
      2006. This employee resigned in December 2007.As a result of these
      delays, we have not been able to sell our investor notes from Maryland or to
      Maryland residents, which is our largest market. Accordingly, our ability to
      raise funds through sales of our investor notes is currently very limited.
      We
      are working diligently with the Maryland Securities Division in furtherance
      of
      this amended registration statement and hope that it will be declared effective
      in the near future.





We
      intend
      to continue managing our assets and maintaining strict collection procedures
      for
      any problem assets in order to increase our profitability. We expect to realize
      more operating efficiencies and cost controls as we invest the proceeds from
      future offerings, as we do not expect significant additional personnel or
      facilities will be needed.





3


**Market
      Area and Credit Risk Concentration**





Our
      lending activities are concentrated primarily in the Washington, D.C. and
      Baltimore, Maryland metropolitan areas. We also purchase residential mortgage
      loans from banks and other lenders in other states. At December 31, 2007, our
      average loan size was approximately $245,000. Our larger loans, above $250,000,
      are made with a strong emphasis on collateral-based underwriting as opposed
      to
      relying primarily on credit scoring.




**Competition**





We
      face
      significant competition both in making loans and in attracting investor funds.
      Our competition for loans comes principally from commercial banks, mortgage
      companies, insurance companies and other financial service companies; often
      these are local (and sometimes smaller) independent loan companies or
      individuals. Our competition for investor funds has historically come from
      competitors offering uninsured products, such as the mutual fund industry,
      securities and brokerage firms and insurance companies, as well as insured
      money
      market accounts and certificates of deposit at commercial banks.





Our
      experience has been that in originating loans and acquiring loans, there has
      been increased competition from large institutions. We do not believe that
      this
      trend is material to our financial condition or operations at this point.
      However, if this trend continues, it is possible that we may have difficulty
      originating or obtaining loans that meet our standards or that we will have
      difficulty competing with these larger originators, which often enjoy a lower
      cost of funds.





Once
      we
      are again able to sell our investor notes in our major markets, we believe
      that
      we will continue to be able to attract investors to our investment products.
      Our
      one, three and five year fixed term investor notes are priced at rates that
      are
      normally more than 200 basis points (2%) above insured investments for a similar
      term at commercial banks. Our one day and 30 day investor notes are
      competitively priced with other uninsured investments that have similar features
      such as checking account and withdrawal features. We provide holders of our
      one
      day demand notes with KH Funding-investor joint checking accounts through Bank
      of America and other local banks to access their funds (this feature is not
      offered to South Carolina residents). The checking account privileges are
      exclusively for funds invested in investor notes and allow the holders of one
      day demand notes to execute redemption or investment requests conveniently,
      quickly and with less expense than by wire transfer or the mail. The holder
      may
      write a check against the account, which reduces the note balance. The holder
      may add to their investment by making deposits at the bank through which the
      checking accounts are provided.





**Lending
      Activities**





Our
      loan
      portfolio consists primarily of first and second mortgage loans that we have
      originated or acquired from other lenders. We also hold several business
      line-of-credit and fixed-term loans that we have directly originated. A small
      portion of our portfolio contains loans for consumer purposes such as auto
      and
      personal loans, and a few loans secured by the borrower’s non-real estate
      assets, such as stock.





Some
      of
      the mortgage loans we make and acquire are considered “sub-prime loans”.
      Sub-prime mortgage loans generally have higher delinquency and default rates
      than mortgage loans made to prime borrowers. At December 31, 2007, our sub-prime
      loans represented 8.81% of our total loans. We attempt to manage these risks
      with risk-based mortgage loan pricing, appropriate underwriting policies,
      appropriate loan collection methods, and reliance on the “hard-collateral” value
      of the underlying collateral for each loan. We believe that our exposure to
      problems in the sub-prime market is limited as a result of several factors.
      First, we believe that we are underwriting our sub-prime mortgage loans to
      a
      higher standard than the failing and delinquent loans from the more aggressive
      lenders in the mortgage industry. Second, we do not offer the loan products
      that
      are receiving the harshest criticism from regulators, commentators and Congress.
      Notably, as a general matter, the sub-prime loans that we originate or purchase
      have loan to value (“LTV”) ratios at the time the loan is made that are less
      than 70%, as opposed to ratios of 95% or higher allowed by many sub-prime
      lenders. In addition, we do not offer so-called “teaser” rate adjustable loans,
      low or no document or “stated income” loans. Third, our size does not require us
      to generate or purchase high volumes of sub-prime mortgage loans so we can
      look
      much more closely at the individual borrowers, as in the case of loans that
      we
      originate. In the case of purchased loans, we rely on strict purchase criteria
      relating to LTV ratios and documentation.





We
      rely
      on community contacts as well as referrals from existing customers, attorneys
      and real estate professionals to generate business within our lending area.
      In
      addition, we have developed a list of brokers, banks and lenders nationwide
      that
      sell us loans.





We
      have
      developed underwriting policies to control the inherent risks in the origination
      and acquisition of loans. The policies address approval limits, loan-to-value
      ratios, appraisal requirements, debt service coverage ratios, loan concentration
      limits and other matters relevant to loan underwriting.




4




***First
      Mortgage Lending***





*Direct
      Origination* .
      We
      primarily originate first mortgage loans for investment (rented) residential
      real estate, and small commercial properties. For these commercial property
      mortgage loans, we require an independent appraisal, title and hazard insurance
      and a recorded deed of trust in our name. In addition, for commercial loans
      we
      generally require an environmental site assessment be performed. Further, we
      may
      require borrowers to make payments to a mortgage escrow account for the payment
      of property taxes and insurance. We monitor to ensure that all applicable taxes
      are paid and insurance is maintained.





At
      origination, these loans generally have LTV ratios of 80% or less, with an
      average of 70%, at the time the loan is made. Credit scores of the borrowers
      generally range in the mid 600’s, with average scores of 500 for sub-prime loans
      and 640 for prime loans. Credit scores are determined by complex computer
      programs which take into consideration many factors. There are three companies
      that are the primary providers of credit reports and credit scores for
      individuals. We generally obtain credit reports and/or credit scores from all
      three companies, and are a member of one, Equifax. Credit scores range from
      the
      400s to the 800s. The lower the score, the lower the “quality” of credit or
      creditworthiness of the individual. Credit scores from 580 to mid-600’s will
      generally indicate a “C/C+” borrower, mid-600s to 680 is an “B-/B/B+” borrower,
      high-600s to low-700s is an “A-” borrower and 720 or higher is an “A” borrower.
      Lenders adopt different guidelines for acceptability regarding credit scores.
      For us a credit score of 580 to the 800s (the highest score possible) is within
      the range of acceptability in order to make or acquire a loan, however, we
      prefer the credit score to be in the mid-600s and above. The borrowers with
      a
      score below the mid-600s must provide us with a reason, or reasons, which
      mitigate the below mid-600s score.





*Acquired
      Loans* .
      The
      first mortgage loans we acquire nationwide are generally 90% LTV, or less,
      and
      they have been made to sub-prime borrowers. The majority of these loans are
      for
      lower-priced properties and the interest rates are usually 9.5% to 11.5%. We
      have not acquired any of these loans since 2004.




***Second
      Mortgage Lending***





*Direct
      Origination* .
      The
      majority of our stand-alone, second mortgage loans, in which we do not hold
      a
      first mortgage on the property, are on owner-occupied properties in which the
      borrowers are consolidating debts. The average LTV at the time the loan is
      made
      is up to 100%. The borrowers’ credit scores generally start at 580 and average
      in the low 600’s. The origination of these loans was discontinued in
      2005.





*Acquired
      Loans* .
      We only
      acquire second mortgage loans if they have a total LTV at the time the loan
      is
      made of less than 100%. We formerly purchased loans with LTVs of up to 125%.
      However, we discontinued that practice in 2000. We also greatly curtailed
      purchasing stand-alone second mortgage loans in 2000, as we would prefer to
      also
      hold the first mortgage when a loan has a combined LTV of more than 90%.
      However, with a credit score in the low to mid 600’s and up, we will still
      purchase stand-alone second mortgage loans.





***Business
      Lending***





We
      directly originate loans to small businesses. We do not acquire small business
      loans. Most of the loans we make of this type are for a business generating
      less
      than $1,000,000 in gross revenue. If the business owns real estate, we will
      obtain a lien on the property(ies) owned by the business as part of our loan.
      If
      the business does not own real estate, we will usually place a lien on the
      primary residence of the owner(s) of the business. We prefer to extend credit
      facilities to a business only when the fair value of the equity in the real
      estate we have a lien on exceeds the loan amount. We are more
      collateral-sensitive when making business loans than we are “cash flow”
sensitive. In other words, if we are considering a loan for a development stage
      or start-up business and we find the business plan or the results of operations
      for the business borrower to be reasonably acceptable, and the credit score
      of
      the borrower to be at the high end of our range of acceptability, then we will
      make the loan provided we are well secured with real estate collateral.
      Generally, the cash flow will not be present at the time the loan is closed,
      but
      will be expected to develop with the use of the loan proceeds. However, we
      do
      require that the borrower(s) have good credit and the current ability to repay
      the loan. In the instances in which a business has accounts receivable as a
      primary source of repayment, we will obtain a lien on the accounts
      receivable.





***Other
      Assets Lending***





Some
      of
      the loans in our portfolio are not secured by real estate or business assets.
      Automobiles and our investor notes secure the majority of these loans. These
      types of loans are generally made to borrowers with whom we have a long-standing
      relationship.





5




***Unsecured
      Lending***





Less
      than
      one percent of our loan portfolio contains unsecured loans. The majority of
      these loans are for small amounts, under $5,000, made to borrowers with whom
      we
      have a long-standing relationship, or who have been referred to us by our
      trusted customers. A few of these loans are to borrowers with whom we originally
      held a collateralized loan, but the collateral has been foreclosed upon and
      the
      balances represent the deficiency.





The
      following table sets forth the composition of our loan portfolio by collateral
      type in dollar amounts for the periods indicated:




**As
                of December 31,****Loans
                By Collateral Type**
            
            
            **2007**
            
            
            **2006**Residential
                Real Estate First Mortgage
            
            $
            11,441,120
            
            $
            15,403,919Business
                Assets and Commercial Real Estate First Mortgage
            
            
            3,049,002
            
            
            2,948,930Residential
                Investment Property First Mortgage
            
            
            30,711,891
            
            
            33,023,531Residential
                Real Estate Second Mortgage
            
            
            750,253
            
            
            1,153,487Other
                Assets (Auto, Stock)
            
            
            1,719,596
            
            
            1,978,712Other
                Loans (Over Equity, Medical and Unsecured)
            
            
            417,008
            
            
            407,751Total
                loans receivable
            
            
            48,088,870
            
            
            54,916,330Unearned
                fees and other
            
            
            291,798
            
            
            239,844Less
                allowance for loan losses
            
            
            (495,480
            )
            
            (452,154
            )Total
                loans receivable, net
            
            $
            47,885,188
            
            $
            54,704,020




***Loan
      Approval Procedures and Authority***





Our
      Chief
      Executive Officer may approve any loan up to and including $500,000. Our Chief
      Executive Officer and another member of our Board of Directors together must
      approve all loans over $500,000.




***Security
      of Loan Collateral Procedures***





We
      have
      no internal appraisers and, as such, we rely on independent appraisers to
      determine the value of collateral underlying a loan. For commercial property
      mortgage loans, in addition to an independent appraisal, we generally require
      an
      environmental site assessment to be performed. We also require title and hazard
      insurance on the property for all first and second mortgage loans. We require
      a
      recorded deed of trust or mortgage. In addition, we may require borrowers to
      make payments to a mortgage escrow account for the payment of property taxes
      and
      insurance. We monitor these loans to ensure that all applicable taxes and
      insurance are timely paid.





**Non-Performing
      Assets**




Non-performing
      assets consist of non-accrual loans and real estate owned and held for sale.
      Loans that are delinquent for more than 90 days are evaluated for collectibility
      and placed in non-accrual status when management determines that future earnings
      on the loans may be impaired. While in non-accrual status, collections on loans,
      if any, are recorded as collection of loan principal and no interest is
      recorded.




Loans
      in
      non-accrual status totaled $510,697 and $651,895 at December 31, 2007 and 2006,
      respectively.




At
      December 31, 2007 and 2006, we had loans of $5,002,259 and $1,748,342,
      respectively, which were more than 90 days past due and for which we continue
      to
      accrue interest. We believe that these loans are adequately collateralized
      and
      that both the principal and the related accrued interest are
      collectible.





Real
      estate owned represents property acquired by foreclosure, deed in lieu of
      foreclosure or purchase, and consists of rental and held for sale real estate.
      At December 31, 2007 and 2006, we had held for sale real estate owned of
      $1,568,655 and $325,223, respectively, which are considered non-performing
      assets. At December 31, 2007 and 2006, we had held for rent real estate owned
      of
      $675,914 and $814,441, respectively.




**Allowance
      for Loan Losses**




We
      maintain an allowance for loan losses. The allowance is increased by
      corresponding charges to provision for loan losses, and by recoveries of loans
      previously written-off. Write-off of a loan decreases the allowance. 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.





6




The
      most
      common known risk in the loan portfolio is a non-performing or impaired loan
      ( *i.e.* ,
      the
      loan is more than 90 days late and the possibility of collection is remote).
      If
      we have specific knowledge or some other reason to consider a loan impaired,
      management reviews the loan to determine if an impairment loss is required.
      Collections on the loan reduce the balance of the impaired asset.





If
      the
      non-accrual loan begins performing again, then it is reclassified as a
      performing asset and will accrue interest retroactively from the last date
      interest had been previously accrued.





If
      the
      impaired loan is only partially recovered, or if after all legal remedies have
      been exhausted no recovery, or no additional recovery, is available, then the
      un-recoverable portion is written off against the loan loss allowance and the
      balance of the loan loss allowance is decreased by the amount of the loan being
      written-off.




Our
      historical loan loss experience is as follows:




**Year
                Ended December 31,**
            
            **Average**
              **Total Loans**
            
            **Write-Offs**
              **Net of Recoveries**
            
            **Percent**2003
            
            $
            15,900,842
            
            $
            111,278
            
            
            0.70
            %2004
            
            $
            17,676,284
            
            $
            244,389
            
            
            1.38
            %2005
            
            $
            32,473,227
            
            $
            114,568
            
            
            0.35
            %2006
            
            $
            49,784,567
            
            $
            230,495
            
            
            0.46
            %2007
            
            $
            51,330,764
            
            $
            466,859
            
            
            0.91
            %




At
      December 31, non-performing assets were as follows:




**2007**
            
            **2006**Loans
                on non-accrual status
            
            $
            510,697
            
            $
            651,895Real
                estate held for sale
            
            
            1,568,655
            
            
            325,223Total
                nonperforming assets
            
            $
            2,079,352
            
            $
            977,118Loans
                90 days past due and still accruing interest
            
            $
            5,002,259
            
            $
            1,748,342




Management
      believes that all of the loans 90 days past-due which are still accruing
      interest are adequately collateralized (based on recent appraisals) and the
      evaluation of guarantees. Management does not anticipate the loss of principal
      or accrued interest receivable on these loans.




**Governmental
      Regulations**





*Federal
      and State Licensing and Supervision*





We
      may
      from time to time be subject to federal and state laws and regulations relating
      to banking or lending operations. These regulations may:


·
            
            require
                us to obtain and maintain additional licenses and
                qualifications;·
            
            Subject
                us to supervision of and examination by regulatory
                agencies;·
            
            limit
                the interest rates, fees and other charges that we are allowed to
                collect;·
            
            limit
                or prescribe other terms of our loan arrangements with borrowers;
                and/or·
            
            subject
                us to potential claims, defenses and other
                obligations.




***USA
      PATRIOT Act***





Congress
      adopted the USA PATRIOT Act (the “Patriot Act”) on October 26, 2001 in response
      to the terrorist attacks that occurred on September 11, 2001. Under the Patriot
      Act, certain financial institutions are required to maintain and prepare
      additional records and reports that are designed to assist the government’s
      efforts to combat terrorism. The Patriot Act includes sweeping anti-money
      laundering and financial transparency laws and required additional regulations,
      including, among other things, standards for verifying client identification
      when opening an account and rules to promote cooperation among financial
      institutions, regulators and law enforcement entities in identifying parties
      that may be involved in terrorism or money laundering. This law may impose
      significant burdens on us to the extent it applies, now or in the future, to
      our
      operations.





7




***Governmental
      Monetary and Credit Policies and Economic Controls***





The
      earnings and growth of the lending industry and ultimately of KH Funding are
      affected by the monetary and credit policies of governmental authorities,
      including the Board of Governors of the Federal Reserve System (the “FRB”). An
      important function of the FRB is to regulate the national supply of credit
      in
      order to control recessionary and inflationary pressures. Among the instruments
      of monetary policy used by the FRB to implement these objectives are open market
      operations in U.S. Government securities, changes in the federal funds rate,
      changes in the discount rate of member bank borrowings, and changes in reserve
      requirements against member bank deposits. These means are used in varying
      combinations to influence overall growth of bank loans, investments and deposits
      and may also affect interest rates charged on loans or paid for deposits. The
      monetary policies of the FRB authorities have had a significant effect on the
      operating results of lending institutions in the past and are expected to
      continue to have such an effect in the future. In view of changing conditions
      in
      the national economy and in the money markets, as well as the effect of actions
      by monetary and fiscal authorities, including the FRB, no prediction can be
      made
      as to possible future changes in interest rates or loan demand or their effect
      on our business and earnings.





***Federal
      Securities Laws***





We
      are
      subject to information reporting and other requirements of the Exchange Act.
      The
      federal Sarbanes-Oxley Act of 2002 and the regulations adopted in furtherance
      thereof made several changes to the Exchange Act to which we are subject. These
      changes impose additional requirements and restrictions on us, including, among
      other things, restrictions on loans to and other transactions with insiders,
      additional disclosure requirements in the reports and other documents that
      we
      file with the SEC, and other corporate governance requirements.





***Environmental
      Laws*** .
      Certain
      environmental regulations may affect our operations. For example, our ability
      to
      foreclose on the real estate collateralizing our loans may be limited by
      environmental laws which pertain primarily to commercial properties that require
      a current or previous owner or operator of real property to investigate and
      clean up hazardous or toxic substances or chemical releases on the property.
      In
      addition, the owner or operator may be held liable to a governmental entity
      or
      to third parties for property damage, personal injury, investigation and cleanup
      costs relating to the contaminated property. While we would not knowingly make
      a
      loan collateralized by real property that was contaminated, it is possible
      that
      the environmental contamination would not be discovered until after we had
      made
      the loan.





***Future
      Legislation***





Periodically,
      the federal and state legislatures consider bills with respect to the regulation
      of financial institutions. Some of these proposals could significantly change
      the regulation of the financial services industry. We cannot predict whether
      such proposals will be adopted or their effect on us if they are
      adopted.





Although
      we believe that we are currently in compliance with statutes and regulations
      applicable to our business, there can be no assurance that we will be able
      to
      maintain compliance with existing or future governmental regulations. The
      failure to comply with any current or subsequently enacted statutes and
      regulations could result in the suspension or termination of our applicable
      laws
      and would have a materially adverse effect on us. Furthermore, the adoption
      of
      additional statutes and regulations, changes in the interpretation and
      enforcement of current statutes and regulations, or the expansion of our
      business into jurisdictions that have adopted more stringent regulatory
      requirements than those in which we currently conduct business could limit
      our
      activities in the future or significantly increase the cost of regulatory
      compliance.





**Insurance**





We
      maintain the following types of insurance for the benefit of KH
      Funding:


·
            
            Bankers
                Bond: fidelity and theft coverage of $500,000;·
            
            Mortgage
                Impairment: covers losses to properties when the borrower’s policy has
                expired;·
            
            Property
                Damage-Vacant Properties: covers losses to properties immediately
                after we
                take title, if they are vacant;·
            
            Liability
                Coverage-Vacant Properties: covers liability losses to individuals
                at
                vacant properties after we take title;·
            
            Key
                Man Life: $2.7 million payable to KH Funding in the event of the
                death of
                Robert L. Harris;




8




·
            
            Key
                Man Disability: $12,000 per month payable for one year to KH Funding
                in
                the event of the disability of Robert L. Harris·
            
            Umbrella
                Liability: $2 million in excess liability coverage above any primary
                liability coverage that we maintain;·
            
            Landlord
                Policies for Individual Rental Properties: basic insurance for rented
                properties;·
            
            Health
                Insurance: maintained for the benefit of the employees;
                and·
            
            Business
                Owners Policy: comprehensive business and liability
                coverage·
            
            Director’s
                and Officer’s Liability:




**Personnel**





At
      December 31, 2007, we had five full-time employees (working more than 30 hours
      per week) and three part-time employees (working fewer than 30 hours per week.)




**Risk
      Factors**




Our
      business, results of operations, financial condition, and investments in our
      securities, including our investor notes, are subject to a number of risks,
      including the risks set forth below. You should carefully consider these risks
      when making investment decisions with respect to KH Funding. Additional risks
      and uncertainties, including those that are not yet identified or that we
      currently think are insignificant, may also adversely affect our business,
      results of operations and financial condition.





***Our
      current ability to raise funds for continued operations is limited due to our
      inability to sell investor notes from or in Maryland.***





Historically,
      a significant portion of our working capital has come from the proceeds of
      sales
      of our investor notes. As noted above, we filed a registration statement with
      the SEC in June 2006 to register the sale of Series 3 and Series 4 investor
      notes in the aggregate amount of $250,000,000. Although the SEC declared this
      registration statement effective, it was not declared effective by the Maryland
      Securities Division. On January 23, 2008, we filed an amendment to the
      registration to bring it up to date and to renew our selling efforts. Again,
      although the SEC declared the amendment effective, the Maryland Securities
      Division has not yet done so. Because
      we sell many of our investor notes from Maryland and to Maryland residents,
      our
      ability to raise funds through sales of our investor notes is currently very
      limited. We are working diligently with the Maryland Securities Division so
      that
      our amended registration statement may be declared effective as soon as
      possible, but we cannot predict when this will occur, if at all. Management
      believes that we have sufficient cash resources and assets to meet
      our current liquidity needs. However, the timing and amounts of investor
      note redemptions are unpredictable, and our limited ability to sell investor
      notes at this time could have a materially adverse impact on our financial
      condition if we were to receive investor note redemption requests in an amount
      that exceeds our cash resources, cash in flows from loans, including unscheduled
      and unpredictable prepayments, and the cash we can obtain through the
      liquidation of our saleable assets to satisfy those redemption requests.
      These liquidity and capital resources concerns, if realized, could jeopardize
      our ability to continue as a going concern. See Note B to the audited financial
      statements presented elsewhere in this report and the section entitled “Liquidity
      and
      Capital Resources” contained
      in Item
      5 of Part II of this report for further information about this
      risk.




***We
      have experienced net losses in recent fiscal years and may not achieve
      consistent profitability.***





In
      the
      last five fiscal years of operation, we reported net losses for the fiscal
      years
      ended December 31, 2007, 2005 and 2004. Although we believe we have a good
      business model, we may not be able to sustain or increase profitability on
      a
      quarterly or an annual basis in the future.





***Our
      assessment of the quality of loans we originate and acquire may be
      inaccurate.***





Before
      we
      purchase or originate loans, we perform an evaluation of the loans in order
      to
      determine whether they are suitable for our portfolio. Our initial evaluation
      of
      the loans may be flawed and actual results may be different than expected which,
      if unfavorable, could adversely affect our financial condition and results
      of
      operations. See the section entitled “Lending Activities” in Item 1 of Part I of
      this report. The majority of our loans are “hard collateral” loans. A hard
      collateral loan is a loan in which the loan amount is equal to or less than
      70%
      of the value of the collateral. Even if these loans default, we underwrite
      them
      in such a manner that the underlying collateral should be adequate to cover
      both
      the principal and interest due on the loan. Nevertheless, in the future, our
      loan loss percentage could increase, our assessment of collateral values may
      be
      inaccurate, and/or collateral values may decrease due to changes in economic
      or
      other conditions, any of which could adversely affect our profitability. See
      the
      section entitled “Allowance for Loan Losses” in Item 1 of Part I of this report.




9


***Our
      borrowers may fail to repay their loans.***





Almost
      all of our income is generated from our lending business. Thus, the primary
      risk
      associated with our business is that persons to whom we lend money will fail
      to
      repay their loans or will fail to make timely payments to us. If any our
      borrowers fail to repay their loans when due, then we may be unable to make
      payments under our Notes and our investors may lose part of all of their
      investments. The risks relating to the ability of our borrowers to repay their
      loans are discussed in more detail below. It is impossible to predict whether
      one of our borrowers will default or what impact any one borrower’s default may
      have on our business.





***Changes
      in the economic conditions in our lending areas could have a material adverse
      impact on our financial condition, the ability of our borrowers to repay their
      loans and the value of the real estate and other collateral securing those
      loans.***





Our
      lending activities are concentrated in the Washington, D.C. and Baltimore,
      Maryland metropolitan areas. Any negative changes that arise in the economy
      and/or real estate market of these areas could have a negative impact on our
      net
      income, the ability of our borrowers to make payments under their loans, and
      any
      recovery we or you can obtain by proceeding against the collateral securing
      those loans. The national and local real estate economies have weakened during
      the past two years in part due to the widely-reported problems in the sub-prime
      mortgage loan market. These problems have had the effect of decreasing the
      amount of credit that is available to borrowers. As a result, sellers of real
      estate and loans secured by real estate have found it more difficult in recent
      years to sell their assets at the times and at the prices they desire. These
      adverse changes in the real estate markets could reduce our ability to make
      pay
      our debts as they come due, including investor note redemption requests.





***Some
      of the loans we make and acquire are sub-prime loans, which generally have
      higher delinquency and default rates than prime mortgage
      loans.***




In
      the
      last five years, we have increased our purchasing of loans originated by
      brokers, banks and other lenders that are considered sub-prime loans and we
      may
      to continue to expand this component of our operations in the future. At
      December 31, 2007, we held sub-prime loans in the amount of $4.19 million,
      or
      8.81% of our total loans. Sub-prime loans are loans made to persons with weak
      credit records or reduced repayment capacities. Sub-prime mortgage loans
      generally have higher delinquency and default rates than mortgage loans made
      to
      prime borrowers. Delinquency interrupts the flow of projected interest income
      from a mortgage loan, and default can ultimately lead to a loss if the net
      realizable value of the real property securing the mortgage loan is insufficient
      to cover the principal and interest due on the mortgage loan.





Recently,
      the sub-prime mortgage banking environment has experienced considerable strain
      from rising delinquencies and liquidity pressures. Several high profile
      sub-prime mortgage lenders have failed. The increased scrutiny of the sub-prime
      lending market is one of the factors that have impacted general market
      conditions, as well as several significant sub-prime mortgage originators.





Although
      we attempt to manage the risks associated with the sub-prime loans that we
      originate and purchase as described in Item 1 of Part I of this report under
      the
      heading “ Lending
      Operations ”,
      if
      there is a major downturn in real estate values and we experience significant
      loan defaults, we may not be able to prevent or materially diminish an adverse
      affect on our financial condition or results of operations. If our underwriting
      and collection policies and methods are insufficient to control our delinquency
      and default risks and do not result in appropriate loan pricing, our business,
      financial condition, liquidity and results of operations could be materially
      and
      adversely impacted.





***We
      operate with limited capital levels and stockholders’
equity.***





Capital
      represents the amount that a corporation’s stockholders have invested in the
      corporation at any point in time. Generally, a stockholder’s right to a return
      on his or her capital investment is subordinate to the other obligations of
      the
      corporation. Accordingly, in the event of a dissolution or liquidation of the
      corporation, capital is paid only after all persons who have a senior right
      to
      payment, such as preferred security holders and holders of debt, have been
      paid.
      A greater amount of capital provides a greater amount of protection to debt
      holders in the event of a liquidation or dissolution. As of December 31, 2007,
      our debt-to-equity ratio is 2.0%, and stockholders’ equity at December 31, 2007
      was 1.95% of our total assets. These levels are not considered adequate to
      fully
      protect our investors against losses in the event we became insolvent or had
      to
      liquidate. Accordingly, holders of our securities could lose all or a part
      of
      their investments if we were to become insolvent or forced to liquidate and
      our
      assets at that time were not sufficient to satisfy our obligations to those
      holders. For further information about this risk, see the section of Item 6
      of
      Part II of this report entitled “Liquidity and Capital Resources”.





***We
      have not established a line of credit with any other lender to provide funds
      for
      operations.***





To
      fund
      our operations and to repay our investor notes, we rely solely on our net income
      from operations and funds received from investors who purchase our investor
      notes and, from time to time, shares of our common stock. We do not maintain
      any
      line of credit with any lender and have no present intention of establishing
      such a line of credit. Accordingly, if our net income and other traditional
      sources of funds are not sufficient to pay our debts and other obligations
      as
      they come due, our operations, and thus our financial condition and results
      of
      operations, could be materially and adversely impacted.





10




***Our
      allowance for loan losses may be insufficient.***





We
      maintain an allowance for loan losses, which is a reserve established through
      a
      provision for loan losses charged to expense, that represents management’s
      estimate of probable losses that have been incurred within the existing
      portfolio of loans. The allowance, in the judgment of management, is necessary
      to reserve for estimated loan losses and risks inherent in the loan portfolio.
      The level of the allowance reflects management’s continuing evaluation of, among
      other things, general economic, political and regulatory conditions, the type
      of
      loan being made, the creditworthiness of the borrower over the term of the
      loan,
      the value and marketability of the collateral for the loan, loan concentrations,
      our loan loss experience, current loan portfolio quality. The determination
      of
      the appropriate level of the allowance for loan losses inherently involves
      a
      high degree of subjectivity and requires us to make significant estimates of
      current credit risks and future trends all of which may undergo material
      changes. If management’s assumptions and judgments prove to be incorrect and the
      allowance for loan losses is inadequate to absorb future losses, our earnings
      and capital could be significantly and adversely affected. Although management
      uses the best information available to make determinations with respect to
      the
      allowance for loan losses, future adjustments may be necessary if economic
      conditions differ substantially from the assumptions used or adverse
      developments arise with respect to our non-performing or performing loans.
      Material additions to the allowance for loan losses would result in a decrease
      in our net income and capital and could have a material adverse effect on our
      financial condition.





***Our
      remedies for collecting on a defaulted loan may be inadequate.***





We
      may
      fail to collect funds from originated and acquired loans. Our ability to fully
      recover amounts due under the originated and acquired loans may be adversely
      affected by, among other things:


·
            
            the
                financial failure of the borrowers;·
            
            adverse
                changes in the values of the real estate or other property that are
                pledged to secure our loans;·
            
            the
                purchase of fraudulent loans;·
            
            misrepresentations
                by a broker, bank or other lender;·
            
            third-party
                disputes; and·
            
            third-party
                claims with respect to security
                interests.




Any
      of
      these events could require us to seek enforcement of a borrower’s guarantee,
      which could prove to be inadequate to fully collect the loans. Therefore, we
      may
      experience losses on acquired or originated loans in the future. These potential
      future losses may be significant, may vary from current estimates or historical
      results and could exceed the amount of our reserves for loan losses. We do
      not
      maintain insurance covering such losses. In addition, the amount of provisions
      for loan losses may be either greater or less than actual future write-offs
      of
      the loans relating to these provisions. Any of these events could have a
      materially adverse effect on our business. See “Allowance for Loan Losses” in
      Item 1 of Part I of this report.




***Our
      lending and investment activities are not diverse.***





Our
      operations primarily consist of, and our income is derived from, investing
      in
      mortgage loans that we purchase from brokers, banks and other lenders and from
      loans that we make to small businesses and individuals. In addition, we invest
      excess cash in investment grade debt securities issued by financial companies
      that we hold for liquidity and investment purposes. Further, we hold as
      investments many of the properties on which we foreclose. Most of these
      properties are held as rental investments. This lack of diversification, of
      investing only in loans, and to a lesser degree in bonds and real estate,
      increases our exposure to the risk of loss if a substantial number of our loans
      become uncollectible. This increases the risk that uncollectible loans could
      materially affect our financial results.





***Our
      lending activities are concentrated in the Washington/Baltimore metropolitan
      areas.***





Our
      success depends in large part on the general economic conditions of the
      Baltimore-Washington metropolitan area. The local economic conditions in the
      areas have a significant impact on the demand for our loans as well as the
      ability of our customers to repay loans, the value of the collateral securing
      loans and the stability of our funding sources. A significant decline in general
      economic conditions, caused by inflation, recession, acts of terrorism, outbreak
      of hostilities or other international or domestic occurrences, unemployment,
      changes in securities markets or other factors could impact these local economic
      conditions and, in turn, have a material adverse effect on our financial
      condition and results of operations.




11




***We
      may not be able to sustain our historical levels of loan originations and
      acquisitions.***





It
      will
      be necessary for us to continue adding loans to our investment portfolio because
      we need to re-invest proceeds of loan payoffs and invest the additional capital
      received from the sale of our Notes. Our ability to sustain the level of loan
      originations and purchases needed depends upon a variety of factors outside
      our
      control, including:


·
            
            interest
                rates;·
            
            economic
                conditions in our primary market area;·
            
            decline
                in real estate values;·
            
            competition;
                and·
            
            regulatory
                restrictions.





***Our
      success is dependent in part on our senior management
      team.***





We
      are
      dependent upon the continued services and experience of our senior management
      team, including Robert L. Harris, our Chief Executive Officer, Chief Financial
      Officer, and President, James E. Parker, a Vice President, Louise B. Sehman,
      our
      Secretary, and Ronald L. Nicholson, a Vice President. We depend on the services
      of Messrs. Harris, Parker, and Nicholson and Ms. Sehman and other future members
      of our senior management team to, among other things, continue our growth
      strategies and maintain and develop our client relationships.





We
      have
      no employment or non-compete agreements with any of our executive officers
      or
      other employees. The loss of the services of any of our senior management or
      any
      of our other key employees would disrupt our operations and would delay our
      planned growth while we worked to replace those employees. We currently have
      in
      place, on a continuing basis, director and officer insurance. We maintain “key
      person” life insurance on Robert L. Harris only. As a result, if any of our
      other key employees were to die or become unable to provide services for us,
      our
      operations would be disrupted and we would have no means of recovering any
      resulting losses. In addition, if Mr. Harris were to die or become unable to
      provide services for us, there is no assurance that the insurance proceeds
      would
      be sufficient to recover any resulting losses.




***Some
      of our officers, directors and principal stockholders have invested in our
      investor notes, which may create conflicts of
      interest.***





As
      of
      December 31, 2007, certain of our officers, directors and principal stockholders
      held investor notes payable in the aggregate principal amount of $11.44 million.
      Although such persons’ relationships with KH Funding encourages them to act in
      our best interests, circumstances could arise where such individuals,
      particularly those that are members of our Board of Directors, will be in a
      position of allocating available cash in a manner that may not be in our best
      interests or the best interests of our other security holders. In addition,
      as
      of December 31, 2007, loans made by us to some of our officers, directors and
      stockholders totaled $10.65 million. Although we believe that each of these
      transactions were on terms as favorable as could have been obtained from an
      unrelated party, they could create, or appear to create, potential conflicts
      of
      interest which may not necessarily be resolved in our favor. This could have
      a
      material adverse effect on our business, operating results and financial
      condition. See the Item 12 of Part III of this report for further information
      about our transactions with related parties.





***We
      have loaned significant amounts of money to some of our officers and
      stockholders.***





From
      time
      to time, in the ordinary course of our business, we make loans to our officers,
      directors and stockholders. At December 31, 2007, we had 12 loans receivable
      totaling $10,649,192, or 22.24% of all loans, from officers, stockholders and
      entities controlled by stockholders. See Note I and Note N to the financial
      statements presented elsewhere in this report for further information about
      these loan concentrations. Of these loans, six loans were made to a significant
      stockholder and/or her affiliates with an aggregate balance due at December
      31,
      2007 of $9.98 million, of which $400,736 is unsecured, $5,705,000 is secured
      by
      first or second mortgages on 10 apartment buildings in Baltimore, Maryland,
      a
      first mortgage on a residential property in Woodbine, Maryland, shares of KH
      Funding common stock and KH Funding investment accounts owned by the borrowers,
      $224,862 is secured by shares of KH Funding common stock, and $3,648,645 is
      secured by a second lien on commercial property in Langley Park, Maryland.
      As of
      December 31, 2007, all of the loans to this stockholder and her affiliates
      were
      past due and on the watch list, but were brought current by March 31, 2008.
      Although these borrowers are current and management believes these loans are
      adequately collateralized based on current appraisals, no guarantees can be
      made
      as to future financial condition of these borrowers or future changes in the
      values of the underlying collateral. Generally, our loans to insiders present
      the same risks as our other loans.





12




***Our
      Board of Directors does not have a separately-designated compensation committee,
      which may cause conflicts of interest with our directors and certain of our
      officers.***





Currently,
      we do not have a compensation committee and do not have plans to form such
      a
      committee. Our Board of Directors makes decisions regarding compensation,
      including the compensation for directors and executive officers. Our Board
      of
      Directors is not entirely comprised of independent members, and our Chief
      Executive Officer, who also serves as our Chief Financial Officer, is a member
      of the Board of Directors. This situation may give rise to conflicts of
      interests between KH Funding and our directors and certain of our officers,
      which may not necessarily be resolved in our favor. This could have a material
      adverse effect on our business, operating results and financial
      condition.




***Our
      lending activities subject us to the risk of environmental
      liabilities.***





A
      significant portion of our loan portfolio is secured by real property. During
      the ordinary course of business, we may foreclose on and take title to
      properties securing certain loans. In doing so, there is a risk that hazardous
      or toxic substances could be found on these properties. If hazardous or toxic
      substances are found, we may be liable for remediation costs, as well as for
      personal injury and property damage. Environmental laws may require us to incur
      substantial expenses and may materially reduce the affected property’s value or
      limit our ability to use or sell the affected property. In addition, future
      laws
      or more stringent interpretations or enforcement policies with respect to
      existing laws may increase our exposure to environmental liability. Although
      we
      have policies and procedures to perform an environmental review before
      initiating any foreclosure action on real property, these reviews may not be
      sufficient to detect all potential environmental hazards. The remediation costs
      and any other financial liabilities associated with an environmental hazard
      could have a material adverse effect on our financial condition and results
      of
      operations.




***Our
      securities are not insured against loss by the FDIC or any governmental
      agency.***





Neither
      the Federal Deposit Insurance Corporation nor any other governmental or private
      agency insures our common stock or our investor notes. The repayment of our
      investor notes is dependent solely upon our earnings, our working capital and
      other sources of liquidity available to us. If these sources of repayment are
      inadequate, investors could lose their entire investment.




***Our
      liquidity and capital resources could be significantly impacted by redemption
      requests from holders of our investor notes.***





We
      do not
      contribute funds on a regular basis to a separate account, commonly known as
      a
      sinking fund, to redeem our investor notes upon maturity. Accordingly, holders
      of the investor notes must rely on our cash reserves, which we fund with
      revenues from operations, and other sources of liquidity (such as saleable
      loans
      and investment securities) for redemption. Our ability to generate revenues
      from
      operations in the future is subject to general economic, financial, competitive,
      legislative, statutory and other factors that are beyond our control. Therefore,
      funds from these sources may not be sufficient to meet our anticipated future
      operating expenditures and debt repayment obligations as they become due.





The
      holders of our one day demand notes are given the option to withdraw funds
      by
      providing one day’s advance notice to us of their redemption request, or through
      the use of a KH Funding-investor joint checking account provided through Bank
      of
      America and other local banks. These redemption privileges necessitate that
      we
      keep adequate cash reserves available to accommodate immediate redemption
      requests, which could cause the company to suffer severe cash fluctuations.
      In
      an attempt to manage this potential risk, we have established “maximum balance”
limits on the amount of our one day and 30 day demand notes that may be held
      by
      any one investor. Specifically, no one investor may hold more than an aggregate
      of $250,000 in one day demand notes and, no one investor may hold more than
      an
      aggregate of $500,000 in our 30 day demand notes. We reserve the right to waive
      these maximum balance limits for any investor; however, we only do so in very
      limited instances and after careful analysis of the facts and circumstances.
      These maximum balance limits do not provide complete protection from the
      possibility of severe cash fluctuations or shortages.





If
      we
      were to experience a large number of redemption requests in a short period
      of
      time and our cash reserves or saleable assets were not sufficient to satisfy
      these requests, holders of our investor notes would not be timely paid and
      could
      lose some or all of their investments. At December 31, 2007, approximately
      $7.52
      million of our one day demand notes were outstanding and approximately $13.85
      million of our 30 day demand notes were outstanding. At that same date, we
      had
      approximately $0.10 million of cash and cash equivalents and approximately
      $11.44 million in residential first mortgage loans that we believe could be
      sold
      to satisfy redemption demands. See Item 5 of Part II of this report under the
      heading “Liquidity and Capital Resources” for a more detailed discussion on our
      liquidity strategy.




13


***We
      have the right to make a mandatory call of the our investor
      notes.***





We
      may
      prepay the outstanding principal amount of our fixed term notes and demand
      notes
      at any time without penalty or premium. If we do so, investors may not be able
      to re-invest with us or elsewhere at comparable interest rates and may,
      therefore, earn less interest income than originally expected.





***Our
      Series 4 investor notes are unsecured and subordinate in right of repayment
      to
      our Series 3 investor notes and any other senior debt we may
      incur.***





Our
      Series 4 investor notes are unsecured obligations of KH Funding and are
      subordinated to our Series 3 investor notes and any other senior debt we may
      incur. If we were to become insolvent, our senior debt would have to be paid
      in
      full prior to payment of our Series 4 investor notes in our liquidation. As
      a
      result, there may not be adequate funds or assets remaining to pay the principal
      and interest on the Series 4 investor notes.





***A
      change in market interest rates may reduce our profits and impair our ability
      to
      repay our investor notes.***





Rapid
      changes, either upward or downward, in interest rates may adversely affect
      our
      profits. Any future rise in interest rates may:


·
            
            reduce
                customer demand for our products;·
            
            widen
                investor spread requirements;·
            
            change
                loan prepayment rates;·
            
            increase
                our cost of funds;·
            
            reduce
                the spread between the rate of interest we receive on loans and interest
                rates we must pay under our investor notes; and·
            
            limit
                our access to borrowings in the capital
                markets.




We
      are
      subject to risks associated with decreases in interest rates because we have
      issued fixed rate investor notes with scheduled maturities of over one year.
      At
      December 31, 2007, we had $16.67 million of fixed rate investor notes with
      scheduled maturities greater than one year. If market interest rates decrease
      in
      the future, the rates paid on our fixed rate investor notes that we issue in
      the
      future could exceed the current market rate paid for similar instruments which
      could result in a reduction in our profitability which could impair our ability
      to repay our investor notes.




**ITEM
      2.**  **DESCRIPTION
      OF PROPERTY**




We **** rent **** office
      space from which we operate our headquarters at 10801 Lockwood Drive, Suite
      370,
      Silver Spring, Maryland 20901. The annual rent for this office space is
      $101,748, and the lease expires on October 31, 2015.





The
      real
      estate we own is generally acquired at foreclosure or through a deed-in-lieu
      of
      foreclosure. The more expensive properties on which we foreclose are sold as
      soon as possible. Generally, we rent out the lower and medium priced
      single-family residential properties we acquire through foreclosure and continue
      ownership for a short period. Often these properties have a rental value that
      is
      high relative to its carrying value. If so, we have an opportunity to maximize
      profits from an ultimate sale by finding a good tenant, making cosmetic and
      appliance upgrades, and then selling the property for, hopefully, a higher
      market value than may have been realized by a quick sale. In order to determine
      the fair market value of a foreclosed property we obtain an appraisal from
      a
      licensed real estate professional. Management believes that our properties
      are
      adequately insured.




We
      currently own residential real estate in the following areas:




·
            one
                property held for sale in Louisville, Mississippi;·
            one
                property held for sale in Gainesville, Georgia;·
            four
                properties held for sale in South Bend, Indiana;·
            one
                rental property in Grand Prairie, Texas;·
            one
                rental property and one property held for sale in Washington,
                DC;·
            one
                rental property in Montgomery, Alabama;·
            one
                rental property in Waco, Texas;·
            two
                rental properties in Leander, Texas; and·
            one
                rental property in Greenwood, South Carolina·
            one
                rental property in Silver Spring, Maryland·
            one
                property held for sale, South
                Carolina




14




**ITEM
      3.**  **LEGAL
      PROCEEDINGS**




On
      March
      8, 2005, we were notified that a lawsuit had been filed against us (in the
      Circuit Court of Montgomery County, Maryland) by SBM Financial, LLC (“SBM”). SBM
      claims to operate a business similar to ours and that we have intentionally
      interfered with its ability to retain their existing investors. We believe
      that
      the SEC has requested that a receiver be appointed to liquidate the assets
      of
      SBM. We believe that this lawsuit has no merit, and we expect it to have no
      material impact on our financial condition or results of operations.





We
      are at
      times, in the ordinary course of business, a party to legal actions normally
      associated with a lending institution. Management believes that no currently
      pending ordinary course litigation is likely to have a material adverse impact
      on our financial condition or results of operations.




**ITEM
      4.**  **SUBMISSION
      OF MATTERS TO A VOTE OF SECURITY HOLDERS**




No
      matters were submitted to a vote of the shareholders during the fourth quarter
      of 2007.




**PART
      II**




**ITEM
      5.**  **MARKET
      FOR COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
      SECURITIES**




**Market,
      Holders and Dividends**





As
      of
      December 31, 2007, there were 52 holders of record of our common stock holding
      2,724,981 shares. There is no established trading market for the shares of
      our
      common stock, and transactions are infrequent and privately negotiated by the
      buyer and seller in each case. Management cannot predict whether any market
      will
      develop in the near future. The following table sets forth, to the extent known
      to us, the high and low sales prices for the shares of our common stock for
      each
      quarterly period of 2006 and 2007.


**2006**
              
              **2007****High**
              
              **Low**
              
              **High**
              
              **Low**First
                  Quarter
              
              $
              3.00
              
              $
              3.00
              
              
              No
                  salesSecond
                  Quarter
              
              
              No
                  sales
              
              
              No
                  sales
              
              
              2.60
              
              
              2.60Third
                  Quarter
              
              
              No
                  sales
              
              
              No
                  sales
              
              
              2.00
              
              
              2.00Fourth
                  Quarter
              
              
              2.60
              
              
              2.60
              
              
              No
                  sales
              
              
              No
                  sales





Cash
      dividends on shares of our common stock are at the discretion of the Board
      of
      Directors, based upon such factors as operating results, financial condition,
      capital adequacy, statutory requirements, and stockholder return. Accordingly,
      there can be no assurance that dividends will be declared in the future. The
      Board suspended paying quarterly dividends after the second quarter of 2007
      to
      preserve capital. The following table sets forth the dividends declared on
      our
      common stock for each quarterly period in 2006 and 2007, stated in cents per
      share.





**2006**
            
            **2007**First
                Quarter
            
            $
            0.02
            
            $
            0.02Second
                Quarter
            
            
            0.02
            
            
            0.02Third
                Quarter
            
            
            0.02
            
            
            0.00Fourth
                Quarter
            
            
            0.02
            
            
            0.00




15




**Equity
      Compensation Plan Information**





The
      following table contains information about these equity compensation plans
      as of
      December 31, 2007:





**Plan Category**
            
            **Number of securities tobe issued upon exerciseof outstanding options,warrants, and rights(a)**
            
            **Weighted-averageexercise price ofoutstanding options,**
              **warrants, and rights(b)**
            
            **Number of securitiesremaining available forfuture issuance underequity compensationplans (excludingsecurities reflected in**
              **column (a))**
              **(c)****Equity
                compensation plans approved by security holders
                (1)**
            
            
            80,000
            
            $
            3.18
            
            
            850,000**Equity
                compensation plans not approved by security holders
                (2)**
            
            
            161,250
            
            $
            2.00
            
            
            N/A**Total**
            
            
            241,250
            
            $
            2.39
            
            
            850,000




(1)
            Securities
                were granted under our 2005 Equity Incentive Plan, which was approved
                by
                stockholders in 2005.


(2)
            Securities
                issued under compensation plans not approved by stockholders include
                stock
                options and common stock purchase warrants issued to employees and
                non-employees (such as directors, consultants, advisors, vendors,
                customers, suppliers and lenders) in exchange for services or other
                consideration provided to us. Both stock options and warrants permit
                the
                recipient to purchase shares of our common stock upon the exercise
                of the
                option or warrant and the payment of the exercise prices specified
                in
                those grants. These issuances were not made pursuant to any formal
                policy
                or plan, but instead were issued on such terms and conditions as
                the Board
                of Directors determined appropriate at the time of grant or sale.





**Recent
      Sales of Unregistered Equity Securities**





The
      only
      sale of unregistered equity securities in 2007 occurred on April 26, 2007.
      This
      sale involved 330 shares of our common stock at a purchase price of $2.60 per
      share. Net proceeds to us were $858. This transaction was consummated without
      registration under the Securities Act of 1933, as amended (the “Securities
      Act”), in reliance upon the exemption from registration provided by Section 4(2)
      of the Securities Act as not involving a public offering.





**ITEM
      6.**  **MANAGEMENT’S
      DISCUSSION AND ANALYSIS OR PLAN OF OPERATION**




**Overview**




Our
      primary business activities consist of originating, acquiring and servicing
      mortgage loans, and issuing interest-bearing debt securities to investors.
      Our
      business operations are conducted solely from our headquarters in Silver Spring,
      Maryland.




We
      emphasize the direct origination of small commercial real estate mortgage loans
      and investment property residential mortgage loans. We purchase first and second
      residential mortgage loans nationwide from other lenders and banks.




We
      have
      over 1,300 investors who have purchased our investor notes dating as far back
      as
      1990. The note purchasers have been attracted primarily through word-of-mouth
      referrals. The proceeds from the sale of our investor notes are used for
      investment in real estate mortgage loans, business loans, investment grade
      debt
      securities and real property and also to redeem outstanding investor notes.
      As
      discussed elsewhere in this report, our ability to sell our investor notes
      in
      our principal markets is currently very limited due to the fact that our amended
      registration statement has not yet been declared effective by the Maryland
      Securities Division. As a result of this delay, our ability to raise funds
      for
      operations outside our regular operations income is also currently very
      limited.





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 is significantly affected by general economic conditions, policies
      established by regulatory authorities and competition.




16




**Summary
      Selected Financial Data**




You
      should consider our summary selected financial information set forth below
      together with the more detailed financial statements included elsewhere in
      this
      report.





**Year
                Ended December 31,****2007**
            
            **2006**
            
            **2005**
            
            **2004**
            
            **2003****Statement
                of Operations Data:**Total
                Interest Income
            
            $
            6,035,475
            
            $
            6,144,252
            
            $
            3,534,054
            
            $
            2,274,933
            
            $
            1,968,514Interest
                Expense
            
            
            4,338,073
            
            
            4,041,679
            
            
            2,412,360
            
            
            1,297,978
            
            
            1,273,677Provision
                for Loan Losses
            
            
            510,185
            
            
            312,858
            
            
            251,048
            
            
            266,700
            
            
            146,379Non-interest
                (Loss) Income
            
            
            (17,086
            )
            
            (78,307
            )
            
            101,078
            
            
            121,637
            
            
            89,987Non-Interest
                Expense
            
            
            1,434,656
            
            
            1,550,840
            
            
            1,016,039
            
            
            929,365
            
            
            634,279Net
                Income (Loss)
            
            
            (264,525
            )
            
            160,568
            
            
            (44,315
            )
            
            (97,473
            )
            
            4,166Per
                Common Share Data:Basic
                Earnings (Loss) Per Share(1)
            
            
            (0.10
            )
            
            0.06
            
            
            (0.02
            )
            
            (0.04
            )
            
            -0-Diluted
                Earnings (Loss) Per Share(1)(2)
            
            
            (0.10
            )
            
            0.06
            
            
            (0.02
            )
            
            (0.04
            )
            
            -0-Dividends
                per share (1)
            
            
            0.04
            
            
            0.08
            
            
            0.10
            
            
            0.15
            
            
            0.15





(1)
            Shown
                in cents per share.




(2)
            Shows
                the potentially dilutive effects of shares issuable under our stock
                option
                plan if the options are not anti-dilutive, shown in cents per
                share.




17





**Year
                Ended December 31,****2007**
            
            **2006**
            
            **2005**
            
            **2004**
            
            **2003****Balance
                Sheet Data:**Cash
                and marketable securities
            
            $
            95,622
            
            $
            4,404,162
            
            $
            7,177,851
            
            $
            3,328,093
            
            $
            4,245,066Loans
                less allowance for loan losses
            
            
            47,885,190
            
            
            54,704,020
            
            
            40,678,941
            
            
            20,144,798
            
            
            15,590,526Real
                estate owned
            
            
            2,244,569
            
            
            1,139,664
            
            
            802,815
            
            
            709,973
            
            
            1,014,254Other
                assets(1)
            
            
            3,167,560
            
            
            3,077,855
            
            
            2,110,938
            
            
            2,039,085
            
            
            2,280,217Total
                assets
            
            
            53,392,939
            
            
            63,325,701
            
            
            50,770,545
            
            
            26,221,949
            
            
            23,090,908Notes
                payable
            
            
            51,219,963
            
            
            61,774,343
            
            
            49,681,335
            
            
            24,817,403
            
            
            19,980,673Participation
                loans
            
            
            261,764
            
            
            -
            
            
            -
            
            
            107,248
            
            
            105,636Other
                liabilities(2)
            
            
            872,146
            
            
            133,044
            
            
            174,403
            
            
            101,446
            
            
            1,322,686Total
                liabilities
            
            
            52,353,873
            
            
            61,907,387
            
            
            49,855,738
            
            
            25,026,097
            
            
            21,408,995Stockholders
                equity
            
            
            1,039,066
            
            
            1,418,314
            
            
            914,807
            
            
            1,195,852
            
            
            1,681,913**Other
                Financial Data:**Return
                on average assets(3)
            
            
            (0.45
            )%
            
            0.28
            %
            
            (0.12
            )%
            
            (0.40
            )%
            
            0.02
            %Return
                on average equity(4)
            
            
            (0.22
            )%
            
            13.76
            %
            
            (4.20
            )%
            
            (6.77
            )%
            
            0.31
            %Stockholders’
                equity to total assets (5)
            
            
            1.95
            %
            
            2.04
            %
            
            1.81
            %
            
            4.56
            %
            
            7.28
            %Stockholders’
                equity to loans outstanding (5)
            
            
            2.17
            %
            
            2.59
            %
            
            2.25
            %
            
            5.94
            %
            
            10.79
            %**Loan
                Portfolio:**Principal
                funded during period
            
            $
            12,412,719
            
            $
            40,285,035
            
            $
            37,727,240
            
            $
            12,841,741
            
            $
            6,875,053Principal
                received during period
            
            $
            16,911,098
            
            $
            26,060,326
            
            $
            16,733,748
            
            $
            8,005,490
            
            $
            6,970,257Average
                interest rate for period
            
            
            10.65
            %
            
            11.05
            %
            
            10.66
            %
            
            10.89
            %
            
            10.74
            %Loan
                charge-offs as a percent of total portfolio at end of
                period
            
            
            0.50
            %
            
            0.46
            %
            
            0.35
            %
            
            1.38
            %
            
            0.75
            %**Investor
                Notes Payable:**Sale
                of notes during period
            
            $
            2,321,330
            
            $
            106,101,789
            
            $
            120,110,831
            
            $
            49,008,102
            
            $
            26,630,166Redemption
                of notes during period
            
            $
            14,912,760
            
            $
            95,933,794
            
            $
            96,630,099
            
            $
            44,786,895
            
            $
            24,697,770Average
                interest expense rate
            
            
            7.09
            %
            
            6.53
            %
            
            6.03
            %
            
            5.69
            %
            
            6.0
            %




(1)
            Consists
                of the sum of the following: accrued interest receivable, prepaid
                expenses, other receivables, investments—other, property and
                equipment-net, and other assets.




(2)
            Consists
                of the sum of the following: other loans payable, accounts payable
                and
                accrued payroll liabilities, long-term lease liability, and escrows
                and
                security deposits.





(3)
            Using
                average of beginning and ending balances for assets, and earnings
                for
                period (annualized).




(4)
            Using
                average of beginning and ending balances for equity, and earnings
                for
                period (annualized).




(5)
            Using
                year-end totals.




**Comparison
      of Financial Condition at December 31, 2007 and 2006**




*Assets* .
      Total
      assets decreased $9.93 million, or 15.69%, to $53.39 million at December 31,
      2007, from $63.33 million at December 31, 2006. The size of the gross loan
      portfolio decreased to $47.89 million at December 31, 2007 from $54.70 million
      at December 31, 2006.  These
      decreases resulted primarily from loan payoffs coupled with our inability to
      fully implement our business strategy by raising capital through the sale of
      our
      investor notes during 2007. In addition, in January 2007 we were required by
      the
      Maryland Securities Division to redeem an aggregate of $464,511 in investor
      notes that were sold to unaccredited investors without registration.





As
      of
      December 31, 2007 and 2006, non-accrual loans totaled $510,697 and $651,895,
      respectively.




18


Information
      related to non-performing assets and accruing past due loans are as
      follows:





**2007**
            
            **2006**Non-accrual
                loans
            
            $
            510,697
            
            $
            651,895Foreclosed
                real estate held for sale
            
            
            1,568,655
            
            
            325,223Total
                non-performing assets
            
            $
            2,079,352
            
            $
            977,118Ratio
                of non-performing assets to:Total
                loans and foreclosed assets
            
            
            4.20
            %
            
            1.78
            %Total
                assets
            
            
            3.89
            %
            
            1.54
            %Loans
                90 days or more past due and still accruing interest
            
            $
            5,002,259
            
            $
            1,748,342Ratio
                of loans 90 days or more past due and still accruing to:Total
                loans
            
            
            10.45
            %
            
            3.19
            %Total
                assets
            
            
            9.37
            %
            
            2.76
            %




As
      of
      December 31, 2007 and 2006, there were loans of $5,002,259 and $1,748,342,
      respectively, more than 90 days past due on the books of the Company that
      continue to earn interest. Management believes that these loans are
      well-collateralized, and the borrowers, in most cases, are making scheduled
      payments.




*Liabilities* .
      Total
      liabilities decreased $9.55 million, or 15.43%, to $52.35 million at December
      31, 2007, from $61.91 million at December 31, 2006. The decrease was largely
      the
      result of the redemption of outstanding investor notes in 2007, including the
      notes that the Securities Division required us to redeem in January
      2007.




*Equity* .
      Total
      stockholders’ equity decreased to $1,039,066 in 2007 from $1,418,314 in 2006 due
      to the payment of cash dividends to common stockholders in 2007 and the current
      years’ net loss of $264,525. These dividends were suspended after the second
      quarter of 2007 to preserve capital.





*Off-Balance
      Sheet Arrangements* .
      We
      enter into off-balance sheet arrangements in the normal course of our business.
      These arrangements consist primarily of our lines-of-credit or draw-type loans.
      At December 31, 2007, we had $6.30 million in loans of this type, compared
      to
      $16.3 million at December 31, 2006. The unused or unfunded amount on these
      types
      of loans totaled $ .98 million at December 31, 2007, compared to $3.42 million
      at December 31, 2006.




In
      addition to our credit commitment as outlined above, we have certain contractual
      obligations that are discussed below under “Liquidity and Capital Resources” of
      this Item 5.





**Comparison
      of Operating Results for Years ended December 31, 2007 and
      2006**




The
      average yield earned on loans receivable decreased to 10.65% for fiscal year
      2007 from 11.05% for fiscal year 2006. The decrease was due primarily to the
      increased payoffs of higher interest rate loans during the falling interest
      rate
      environment of 2007.




The
      average rate paid on investor notes increased to 7.09% for fiscal year 2007
      from
      6.53% for fiscal year 2006. The net result was a decrease in net interest rate
      spread, which was 3.56% for 2007 as compared to 4.52% in 2006.




*Net
      (Loss) Income* .
      Net
      loss for the year ended December 31, 2007 was $264,525, compared to net income
      of $160,568 for the year ended December 31, 2006. The loss in 2007 was due
      primarily to $60,000 in write downs related to two real estate properties held
      as real estate owned that were acquired prior to 2007 to recognize a
      deterioration in property condition and market conditions, and mark-downs to
      net
      realizable value of two properties acquired by foreclosure in 2007. The two
      properties acquired in 2007 were originally booked at an aggregate fair market
      value of $1.55 million. Historically, we carried real estate owned on our books
      at market value, but beginning this year we reduced the values by an additional
      10% to cover costs of sale to provide for a more conservative book value. This
      change resulted in a combined $155,000 write down on these two loans.
      Additionally, our ability to make and acquire loans in 2007 and 2006 was
      hampered by our inability to raise funds through the sale of our investor
      notes.





*Interest
      Income* .
      Total
      interest income was $6.04 million in 2007, compared to $6.14 million in 2006.
      The decrease resulted primarily from a decrease in loans outstanding due to
      the
      increased frequency of loan payoffs in 2007. The interest income for all periods
      includes point and fee income, interest earned on bank investments and
      marketable securities.




19





*Interest
      Expense* .
      Interest expense was $4.34 million in 2007, compared to $4.04 million for 2006.
      The increase resulted from an increase in the average rate paid on investor
      notes to 7.09% in 2007 from 6.53% in 2006. The interest expense includes fees
      paid to broker-dealers who sold our investor notes.




*Provision
      for Loan Losses* .
      The
      provision for loan losses was $510,185 in 2007 and $312,858 in 2006. Our
      non-accrual loans were $510,697 at December 31, 2007 and $651,895 at December
      31, 2006, and our foreclosed real estate held for sale was $1,568,655 and
      $325,223, at those same respective dates. Our allowance for loan losses was
      $495,480 at the end of 2007 and $452,154 at the end of 2006. Relative to loan
      write-offs in 2007 of $466,860, our provision for loan losses of $510,185 is
      about 109% of our write-offs.




*Non-Interest
      (Loss) Income* .
      We had
      a non-interest loss of $17,086 in 2007 and a non-interest loss of $78,307 in
      2006. The loss in 2007 was due to a write down of an investment held for sale,
      a
      loss on the sale of investment securities and losses on the sale of real
      estate.




*Non-Interest
      Expense* .
      Non-interest expense decreased to $1,434,656 in 2007 from $1,550,840 in 2006.
      The decrease was the result of reductions of $67,329 in investor note offering
      cost expenses and $62,246 in real estate maintenance expenses.





*Income
      Taxes* .
      KH
      Funding has elected to be treated as a Subchapter S corporation under the
      Internal Revenue Code and accordingly no income tax items appear in the
      financial statements. An S Corporation is an IRS tax classification for a
      domestically owned corporation with no more than 100 owners who have elected
      to
      pay taxes under Subchapter S of the Internal Revenue Code. An S corporation
      receives the protection of the corporate form, but is taxed like a partnership;
      it is exempt from the corporate income tax, but its profits flow directly to
      the
      stockholders, where they are taxed as personal income.




**Liquidity
      and Capital Resources**





To
      make
      and acquire loans, to satisfy redemption requests from holders of our investor
      notes and to otherwise fund operations, we depend on the availability of cash
      and cash equivalents. Our primary sources of cash are principal and interest
      payments on loans, proceeds from the sales of participation interests in loans,
      income from our investments, rental income, and the proceeds from the sale
      of
      investor notes. While maturities and scheduled amortization of loans and
      investments are predictable sources of funds, the sale of investor notes and
      mortgage loan prepayments are unpredictable and greatly influenced by interest
      rate trends, economic conditions and competition. Our one day demand notes
      are a
      major cause of turnover in our cash positions. During 2007, we received
      approximately $17.1 million in loan payments, which included unscheduled
      prepayments and payments due at maturity, and paid approximately $12.6 million
      in net investor note redemptions.





If
      funds
      are not readily available to meet our liquidity needs, we historically have
      sold
      some of our mortgage loans and available-for-sale investment securities. We
      generally buy and originate more loans than are readily saleable, but we try
      to
      structure our acquisitions so that we have the ability to sell these loans
      and
      increase our cash position in a relatively short period of time. At December
      31,
      2007, we held more than $11.44 million in mortgage loans that we believe could
      be sold within a short period of time. It should be noted, however, that the
      national and local real estate economies have weakened during the past two
      years
      in part due to the widely-reported problems in the sub-prime mortgage loan
      market. These problems have had the effect of decreasing the amount of credit
      that is available to borrowers. As a result, sellers of real estate and loans
      secured by real estate have found it more difficult in recent years to sell
      their assets at the times and at the prices they desire. We, and our ability
      to
      liquidate assets to satisfy liquidity needs, could be adversely impacted by
      this
      uncertain real estate market. At December 31, 2007, we had no available-for-sale
      investment securities, compared to $581,149 at December 31, 2006. The decline
      in
      available-for-sale securities resulted primarily from the sale of these
      securities during 2007 to fund operations and the fact we are not actively
      investing in marketable securities because their rates have remained constant,
      while the Federal-Funds Target Rate has increased, therefore reducing the margin
      and making them a less attractive investment option. We expect to begin
      investing in marketable securities again when corporate bond rates increase,
      but
      in the meantime, we are investing more in lower yielding loans that can be
      sold
      quickly.





As
      stated
      above, however, our ability to sell investor notes in our principal markets
      is
      currently very limited due to delays in registering our current offering with
      the Maryland Securities Division. Our cash and cash equivalents have been
      significantly impacted by this delay. At December 31, 2007, cash and cash
      equivalents were $0.10 million, compared to outstanding one day demand notes
      of
      $7.52 million and outstanding 30 day demand notes of $13.85 million. Overall
      our
      cash dropped during 2007 and 2006 due to payments and payoffs of mortgage loans.
      Additionally, redemptions of our investor notes in 2006 and 2007 exceeded sales
      of investor notes due to our limited ability to sell investor notes. During
      2007, we accepted loans (Other loans payable) from some of our existing security
      holders in the net amount of $.70 million.





Management
      believes that the risk of not being able to fund investor note redemption
      requests exists only 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 an investor
      note, the funds for redemption are immediately available. Part of our investment
      strategy is to invest proceeds of sales of our investor notes into higher
      yielding, less liquid investments, such as mortgages, in which case the funds
      are available, just not immediately. Only holders of one day demand investor
      notes can ask for funds sooner than 30 days after investment, and we make an
      effort to keep funds available for these requests. Holders of 30 day demand
      investor notes can ask for funds sooner than 90 days after investment. All
      other
      types of investor notes are redeemable upon maturity, or prior to maturity
      on 90
      days advance notice, subject to a penalty. We strive to maintain sufficient
      liquidity to meet all anticipated redemption requests. To this end, we normally
      hold 5% to 20% of our assets in cash and cash equivalents to fund redemptions
      of
      one day demand notes, which has historically been sufficient for us to meet
      our
      obligations.





20




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




**Year**
            
            **Notes Sold**
            
            **Notes Redeemed**
            
            **Percentage**2003
            
            $
            26,630,166
            
            $
            24,697,770
            
            
            92.74
            %2004
            
            $
            49,008,102
            
            $
            44,786,895
            
            
            91.39
            %2005
            
            $
            120,110,831
            
            $
            96,630,099
            
            
            80.45
            %2006
            
            $
            106,101,789
            
            $
            95,933,794
            
            
            90.42
            %2007
            
            $
            2,321,330
            
            $
            14,912,760
            
            
            (1
            )


(1)
      not
      meaningful





The
      maturities of investor notes at December 31, 2007 are as follows:


**Balance****Series
                  3 Demand Notes**One
                  Day
              
              $
              7,519,91430
                  Day
              
              
              13,848,001
 **Series
                  3 Fixed Term Notes:**Due
                  within 1 year
              
              
              9,748,504Due
                  in 1 to 3 years
              
              
              6,227,802Due
                  in 3 to 5 years
              
              
              7,129,547
 **Series
                  4 Fixed Term Notes:**Due
                  within 1 year
              
              
              2,122,904Due
                  in 1 to 3 years
              
              
              337,031Due
                  in 3 to 5 years
              
              
              4,417,792Subtotal
              
              
              51,351,495Unamortized
                  brokerage costs
              
              
              (131,532
              )Total
                  investor notes, net
              
              $
              51,219,963





All
      one,
      three and five year fixed term investor notes are redeemable upon maturity,
      or
      prior to maturity on 90 days advance notice, subject to a penalty. These
      features were designed to provide us with ample notice for redemptions. If
      necessary, we sell loans individually or in bulk to fund requests from holders
      of these notes. For example, at December 31, 2007, we held $42.15 million in
      first lien residential and investment property loans that we believe can be
      sold
      in part to a participant bank or in whole to other lenders. Further, we held
      $3.80 million in business line-of-credit loans and second lien loans which
      earn
      higher yields than the first trust loans and can also be sold, although
      generally they take longer to sell and are sold at a discount. The estimated
      market value of these loans exceeds the outstanding balance of our outstanding
      one day demand and 30 day demand notes, under which the investor could request
      redemption at December 31, 2007 of $ 21.38 million. See Note B and Note D to
      our
      financial statements included elsewhere in this report for additional
      information about our liquidity.




We
      intend
      to continue to expand our operations through future public offerings of investor
      notes marketed by us and select, contracted broker-dealers and from the private
      placement of our common stock. We also intend to increase our capital level
      as a
      percent of total assets through the private sale of stock from time-to-time.
      However, there is no assurance that such transactions will occur, especially
      in
      light of the current delay in the effectiveness of our amended registration
      statement covering the sale of investor notes.




Once
      we
      are again able to sell investor notes, we expect that we will be able to attract
      more investors who are interested in our longer-term fixed rate notes. We are
      now 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 longer-term nature, which complements our
      preferred mode of investing.




Net
      proceeds from our investor note offerings received in prior years have been
      used
      to fund new loans. However, rather than directly originating new loans, in
      the
      last five years we have purchased ever-larger portions of loans that have been
      added to our portfolio and are now purchasing approximately 80% of our new
      loans. We intend to continue the expansion of this wholesale component of our
      operations and have it be a major part of our loan acquisition strategy. This
      increased wholesale component should enable us to expand our operations and
      increase our net profit with a limited amount of additional personal and expense
      because we anticipate that only a minimal expansion of our administrative
      functions will be needed to support an increased wholesale component in our
      operations.




21




Additionally,
      we intend to purchase more liquid, marketable loans and to increase the volume
      of loans we purchase. To increase our investment and portfolio activity, we
      plan
      to identify and utilize additional brokers, lenders and banks as sources for
      our
      loan acquisitions.




**Known
      Trends, Events or Uncertainties**




Impact
      of
      Inflation and Interest Rates - Our financial statements and notes thereto,
      presented elsewhere herein, have been prepared in accordance with U.S. generally
      accepted accounting principles, 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 we make. Unlike typical industrial
      companies, nearly all of our assets and liabilities are monetary in nature.
      As a
      result, interest rates have a greater impact on our financial performance than
      the effects of inflation generally have on the typical industrial
      companies.







**Critical
      Accounting Policies**




The
      SEC
      has issued guidelines on the disclosure of critical accounting policies, which
      are those policies that require application of management’s most difficult,
      subjective or complex judgments, often as a result of the need to make estimates
      about the effect of matters that are inherently uncertain and may change in
      subsequent periods.




Our
      significant accounting policies are disclosed in Note A to the audited financial
      statements presented elsewhere in this report. 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 foreclosure is probable.




*Allowance
      for Loan Losses* .
      We
      periodically evaluate the adequacy of the allowance for loan losses based on
      our
      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 or assessments are inherently subjective and future adjustments
      to
      the allowance may be necessary if economic or other 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.




**Recent
      Accounting Pronouncements**




***Pronouncements
      Adopted***




In
      February 2006, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards (“SFAS”) No. 155, Accounting
      for Certain Hybrid Financial Instruments—an amendment of FASB Statements
      No. 133 and 140. This statement amends SFAS No. 133 and SFAS
      No. 140 by: permitting fair value remeasurement for any hybrid financial
      instrument that contains an embedded derivative that otherwise would require
      bifurcation; clarifying which interest-only strips and principal-only strips
      are
      not subject to the requirements of SFAS No. 133; establishing a requirement
      to evaluate interests in securitized financial assets to identify interests
      that
      are freestanding derivatives or that are hybrid financial instruments that

      contain an embedded derivative requiring bifurcation; clarifying that
      concentrations of credit risk in the form of subordination are not embedded
      derivatives; and amending SFAS No. 140 to eliminate the prohibition on a
      qualifying special-purpose entity from holding a derivative financial instrument
      that pertains to a beneficial interest other than another derivative financial
      instrument. The statement is effective for fiscal years beginning after
      September 15, 2006. The adoption of this standard did not have a material
      impact on our financial condition, results of operations or liquidity.




In
      March
      2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial
      Assets—an amendment of FASB Statement No. 140. This statement amends SFAS
      No. 140 with respect to the accounting for separately recognized servicing
      assets and servicing liabilities. It requires an entity to recognize a servicing
      asset or servicing liability each time an obligation is undertaken to service
      a
      financial asset by entering into a servicing contract in certain situations
      and
      requires all separately recognized servicing assets and liabilities to be
      initially measured at fair value, if practicable. The statement permits the
      choice between the “amortization method” and the “fair value measurement method”
for the subsequent measurement of the servicing assets or liabilities and allows
      for a one-time reclassification of available-for-sale securities to trading
      securities at initial adoption. The statement also requires separate
      presentation of servicing assets and servicing liabilities subsequently measured
      at fair value in the statement of financial position and additional disclosures
      for all separately recognized servicing assets and servicing liabilities. The
      statement is effective for fiscal years beginning after September 15, 2006.
      The adoption of this standard did not have a material impact on our financial
      condition, results of operations or liquidity.




22




In
      July
      2006, the FASB issued FASB Interpretation No. 48, Accounting for
      Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.
      The interpretation clarifies the accounting for uncertainty in income taxes
      recognized in a company’s financial statements in accordance with SFAS
      No. 109, Accounting for Income Taxes. The interpretation prescribes a
      recognition threshold and measurement attribute for the financial statement
      recognition and measurement of a tax position taken or expected to be taken
      in a
      tax return. It also provides guidance on derecognition, classification, interest
      and penalties, accounting in interim periods, disclosures, and transition.
      In
      May 2007, the FASB issued FASB Interpretation No. 48-1, Definition of
      Settlement in FASB Interpretation No. 48, which provides guidance on how an
      enterprise should determine whether a tax position is effectively settled for
      the purpose of recognizing previously unrecognized tax benefits. These
      interpretations are effective for fiscal years beginning after December 15,
      2006. The adoption of these interpretations did not have a material impact
      on
      our financial condition, results of operations or liquidity.




In
      September 2006, the FASB issued SFAS No. 157, Fair Value Measurements. This
      statement defines fair value, establishes a framework for measuring fair value
      in generally accepted accounting principles, and expands disclosures about
      fair
      value measurements. The statement is effective for financial statements issued
      for fiscal years beginning after November 15, 2007. We adopted this
      standard effective January 1, 2008, with no material impact on our financial
      condition, results of operations or liquidity.




***Pronouncements
      Issued But Not Yet Effective***




In
      September 2006, the FASB ratified the consensus reached by the Emerging Issues
      Task Force (“EITF”) on Issue No. 06-4, Accounting for Deferred Compensation
      and Postretirement Benefit Aspects of Endorsement Split-Dollar Life Insurance
      Arrangements. EITF 06-4 requires the recognition of a liability and related
      compensation costs for endorsement split-dollar life insurance policies that
      provide a benefit to an employee that extends to postretirement periods as
      defined in SFAS No. 106, Employers’ Accounting for Postretirement Benefits
      Other Than Pensions. The EITF reached a consensus that Bank Owned Life Insurance
      policies purchased for this purpose do not effectively settle the entity’s
      obligation to the employee in this regard and, thus, the entity must record
      compensation costs and a related liability. Entities should recognize the
      effects of applying this Issue through either, (a) a change in accounting
      principle through a cumulative-effective adjustment to retained earnings or
      to
      other components of equity or net assets in the balance sheet as of the
      beginning of the year of adoption, or (b) a change in accounting principle
      through retrospective application to all prior periods. This Issue is effective
      for fiscal years beginning after December 15, 2007. The adoption of this
      standard is not expected to have a material impact on our financial condition,
      results of operations or liquidity.




In
      February 2007, the FASB issued SFAS 159, “The
      Fair
      Value Option for Financial Assets and Liabilities.” SFAS 159
      permits entities to measure many financial instruments and certain other items
      at fair value. The objective is to improve financial reporting by providing
      entities with the opportunity to mitigate volatility in reported earnings caused
      by measuring related assets and liabilities differently without having to apply
      complex hedge accounting provisions. This pronouncement is effective as of
      the
      beginning of an entity’s first fiscal year beginning after November 15, 2007. We
      do not expect the implementation of SFAS 159 to have a material impact on our
      financial position or results of operations.




On
      November 5, 2007, the SEC released Staff Accounting Bulletin (“SAB”) 109,
      Written Loan Commitments Recorded at Fair Value Through Earnings. This SAB
      supersedes SAB 105 and expresses the current view that, consistent with the
      guidance in SFAS No. 156, Accounting for Servicing of Financial Assets—an
      amendment of FASB Statement No. 140, and SFAS No. 159, The Fair Value
      Option for Financial Assets and Financial Liabilities—Including an amendment of
      FASB Statement No. 115, the expected net future cash flows related to the
      associated servicing of the loan should be included in the measurement of all
      written loan commitments that are accounted for at fair value through earnings.
      Management has evaluated the effects of the rule and does not anticipate a
      material impact on our financial statements.




In
      December 2007, the FASB issued SFAS 141, Revised 2007 (SFAS 141R), “Business
      Combinations.” SFAS
      141R’s objective is to improve the relevance, representational faithfulness, and
      comparability of the information that a reporting entity provides in its
      financial reports about a business combination and its effects. SFAS 141R
      applies prospectively to business combinations for which the acquisition date
      is
      on or after December 15, 2008. We do not expect the implementation of SFAS
      141R
      to have a material impact on our financial statements.




In
      December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in
      Consolidated Financial Statements—an amendment of ARB No. 51. This
      statement amends ARB 51 to establish accounting and reporting standards for
      the
      noncontrolling interest in a subsidiary and for the deconsolidation of a
      subsidiary. It also amends certain of ARB 51’s consolidation procedures for
      consistency with the requirements of SFAS No. 141 (revised 2007), Business
      Combinations. This statement is effective for fiscal years, and interim periods
      within those fiscal years, beginning on or after December 15, 2008.
      Management does not anticipate the adoption of this standard to have a material
      impact on our financial statements.




23


**ITEM
      7.**  **FINANCIAL
      STATEMENTS**




**Index
      to Financial Statements**





**Report
                of Independent Registered Public Accounting Firm**
            
            
            25**Management’s
                Report on Internal Control Over Financial
                Reporting**
            
            
            26**Audited
                Financial Statements:**Balance
                Sheets as of December 31, 2007 and 2006
            
            
            28Statements
                of Operations for the years ended December 31, 2007 and
                2006
            
            
            29Statements
                of Changes in Stockholders’ Equity for the years ended December 31, 2007
                and 2006
            
            
            30Statements
                of Cash Flows for the years ended December 31, 2007 and
                2006
            
            
            31Notes
                to Financial Statements for the years ended December 31, 2007 and
                2006
            
            
            32





24


**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




Board
      of
      Directors and Stockholders


KH
      Funding Company


Silver
      Spring, Maryland




We
      have
      audited the accompanying balance sheets of KH Funding Company (the “Company”) as
      of December 31, 2007 and 2006, and the related statements of operations, changes
      in stockholders’ equity and cash flows for the years then ended. These financial
      statements are the responsibility of the Company’s management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.




We
      conducted our audits in accordance with standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. The Company is not required to
      have, nor were we engaged to perform, an audit of internal control over
      financial reporting. Our audits included consideration of internal control
      over
      financial reporting as a basis for designing audit procedures that are
      appropriate in the circumstances, but not for the purposes of expressing an
      opinion on the effectiveness of the Company’s internal control over financial
      reporting. Accordingly, we express no such opinion. An audit also includes
      examining, on a test basis, evidence supporting the amounts and disclosures
      in
      the financial statements, assessing the accounting principles used and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.




In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the financial position of the Company as of December 31,
      2007
      and 2006, and the results of its operations and cash flows for the years then
      ended in conformity with accounting principles generally accepted in the United
      States of America.





The
        accompanying financial statements have been prepared assuming the Company
        will
        continue as a going concern. As is more fully explained in Note B to the
        financial statements, the Company has not yet gained approval from the
        Securities Division of the Office of the Maryland Attorney General to offer
        and
        sell certain investor notes from Maryland or to Maryland residents. Although
        the Company is presently able to meet its current liquidity needs, this
        delay and resulting inability to raise capital through sales of investor
        notes
        presents a significant risk that the Company may have difficulty meeting
        its
        future liquidity needs, which include making and acquiring loans, redeeming
        outstanding investor notes, and paying other operational expenses. This risk
        would be realized if the Company were to receive investor note redemption
        requests, the timing and amounts of which are unpredictable, in amounts that
        exceed its cash resources, cash inflows from loans, including unscheduled
        and
        unpredictable prepayments, and the cash it can obtain through the liquidation
        of
        saleable assets. Additionally,
        stockholders’ equity at December 31, 2007 has decreased to 1.95% of total assets
        which we believe is inadequate to fully protect against potential losses.
        Although the Company has been able to meet its liquidity needs in the past
        through sources of funds other than investor note proceeds, the Company's
        current situation raises substantial
        doubt about the Company’s ability to continue as a going concern. The
        accompanying financial statements do not include any adjustments that might
        result from the outcome of these uncertainties.




/s/
      Stegman & Company




Baltimore,
      Maryland


April
      10,
      2008




25


**MANAGEMENT’S
      REPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**




The
      management of the Company is responsible for establishing and maintaining
      adequate internal control over financial reporting as defined in Rules 13a-15(f)
      and 15d-15(f) under the Exchange Act. The Company’s internal control over
      financial reporting is designed to provide reasonable assurance regarding the
      reliability of financial reporting and the preparation of financial statements
      for external purposes in accordance with generally accepted accounting
      principles in the United States of America. The Company’s internal control over
      financial reporting includes those policies and procedures that: (i) pertain
      to
      the maintenance of records that, in reasonable detail, accurately and fairly
      reflect the transactions and dispositions of the assets of the Company; (ii)
      provide reasonable assurance that transactions are recorded as necessary to
      permit preparation of financial statements in accordance with generally accepted
      accounting principles, and that receipts and expenditures of the Company are
      being made only in accordance with authorizations of management and directors
      of
      the Company; and (iii) provide reasonable assurance regarding prevention or
      timely detection of unauthorized acquisition, use or disposition of the
      Company’s assets that could have a material effect on the financial statements.




This
      annual report on Form 10-KSB does not include an attestation report of the
      Company’s registered public accounting firm regarding internal control over
      financial reporting because management’s report was not subject to attestation
      pursuant to temporary rules of the SEC that permit the Company to provide only
      this management’s report.




Because
      of its inherent limitations, internal control over financial reporting may
      not
      prevent or detect misstatements. Also, projections of any evaluation of
      effectiveness to future periods are subject to the risk that controls may become
      inadequate because of changes in conditions, or that the degree of compliance
      with the policies or procedures may deteriorate. A control system, no matter
      how
      well designed and operated can provide only reasonable, but not absolute,
      assurance that the control system’s objectives will be met. The design of a
      control system must reflect the fact that there are resource constraints, and
      the benefits of controls must be considered relative to their cost.





Management
      assessed the effectiveness of the Company’s internal control over financial
      reporting as of December 31, 2007. In making this assessment, management
      used the criteria set forth by the Committee of Sponsoring Organizations of
      the
      Treadway Commission in Internal Control-Integrated Framework (the “COSO
      Framework”). Based on its evaluation, management has concluded that there are
      material weaknesses in our internal control over financial reporting and that,
      accordingly, the Company’s internal control over financial reporting was not
      effective as of December 31, 2007.





A
      “material weakness” is defined as a deficiency, or a combination of
      deficiencies, in internal control over financial reporting such that there
      is a
      reasonable possibility that a material misstatement of the annual or interim
      financial statements will not be prevented or detected on a timely basis. A
      “significant deficiency” is a deficiency, or a combination of deficiencies, in
      internal control over financial reporting that is less severe than a material
      weakness, yet important enough to merit attention by those responsible for
      oversight of a company’s financial reporting.





The
      material weaknesses relate to the following:





·
            Lack
                of tangible audit trails, such as documentation, dates, and signatures,
                of
                the performance of control activities such as review of journal entries,
                reconciliation of accounts, and valuation of collateral and properties.





·
            Missing
                supporting documentation for loan
                files.





·
            We
                had one person, Mr. Harris, performing the roles of the Chief Executive
                Officer and Chief Financial Officer. As a result, the Company did
                not
                maintain adequate segregation of duties within our critical financial
                reporting applications, the related modules and financial reporting
                processes.





·
            CEO/CFO
                membership on the Audit Committee of the Board of Directors, which
                prevented the Audit Committee from being comprised solely of independent
                directors during 2007.





Although
      management believes that appropriate control activities are performed by Company
      personnel, we recognize the need for better documentation so that the
      performance of our business and controls can be independently verified through
      our periodic internal control assessments. We are currently taking steps to
      implement audit trails for all key control activities. Also, we are in the
      process of reviewing the loan and investor files and obtaining any missing
      information so that all incomplete loan and investor files can be made complete.
      Because the Company has a limited number of employees, management has a
      significant level of involvement in the activities of the Company. Moreover,
      management believes that the Company’s operations are not overly complex and
      that, accordingly, the performance of the CEO and CFO roles can be managed
      by a
      single person. The Company’s current capital resources are limited, and the
      hiring of a separate CFO will likely further limit these resources.
      Nevertheless, the Company plans to separate the CEO and CFO duties currently
      handled by Mr. Harris by hiring a Chief Financial Officer during 2008. Finally,
      Mr. Harris resigned as member of the Audit Committee effective January 16,
      2008.
      The Company will report on progress in improving these controls throughout
      2008.





26




Even
      though management is not aware of any instance in which the Company failed
      to
      identify or resolve a control or disclosure matter or failed to perform a timely
      and effective review, the deficiencies described above could result in a
      misstatement of balance sheet and income statement accounts and statements
      of
      cash flow in our interim or annual financial statements that would not be
      prevented or detected. Accordingly, management has determined that these
      deficiencies constitute material weaknesses.





Notwithstanding
      management’s assessment that our internal control over financial reporting was
      not effective as of December 31, 2007, management believes that the financial
      statements included in this annual report correctly present in all material
      respects our financial position, results of operations and cash flows for the
      fiscal years covered herein.




April
      14,
      2008




/s/
              Robert L. HarrisPresident,
                Chief Executive Officer, and
              Chief
                Financial Officer




27




**KH
      Funding Company**




Balance
      Sheets as of December 31,





**2007**
            
            **2006*****Assets***Cash
            
            $
            95,622
            
            $
            3,823,013Investments
                available for saleMarketable
                securities - at fair value
            
            
            -
            
            
            581,149Other
            
            
            25,436
            
            
            50,872Loans
                receivable, less allowance for loan losses of (2007) $495,480 and
                (2006) $452,154
            
            
            47,885,188
            
            
            54,704,020Accrued
                interest receivable
            
            
            2,668,649
            
            
            1,961,683Other
                receivables
            
            
            106,944
            
            
            611,397Prepaid
                expenses
            
            
            208,550
            
            
            294,496Property
                and equipment-net
            
            
            141,993
            
            
            143,419Real
                estate ownedRental
                property
            
            
            675,914
            
            
            814,441Held
                for sale
            
            
            1,568,655
            
            
            325,223Other
                assets
            
            
            15,988
            
            
            15,988**Total
                Assets**
            
            **$**
            **53,392,939**
            
            **$**
            **63,325,701*****Liabilities
                and Stockholders’ Equity*****Liabilities**Notes
                and accrued interest payable
            
            $
            51,219,963
            
            $
            61,774,343Other
                loans payable
            
            
            702,094
            
            
            -Accounts
                payable and accrued expenses
            
            
            32,827
            
            
            591Escrows
                and security deposits
            
            
            101,383
            
            
            111,064Long
                term liabilities
            
            
            35,842
            
            
            21,389Participation
                loans
            
            
            261,764
            
            
            -**Total
                Liabilities**
            
            
            52,353,873
            
            
            61,907,387**Stockholders’
                Equity**Common
                stock (5,000,000 shares authorized; 2,724,981 shares (2007) and 2,726,951
                shares (2006), issued and outstanding;
                $0.01 par value)
            
            
            27,250
            
            
            27,269Paid-in
                capital
            
            
            1,730,911
            
            
            1,879,783Accumulated
                deficit
            
            
            (533,645
            )
            
            (269,120
            )Subscription
                note receivable
            
            
            (185,450
            )
            
            (185,450
            )Accumulated
                other comprehensive loss
            
            
            -
            
            
            (34,168
            )**Total
                Stockholders’ Equity**
            
            
            **1,039,066**
            
            
            **1,418,314****Total
                Liabilities and Stockholders’ Equity**
            
            **$**
            **53,392,939**
            
            **$**
            **63,325,701**




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





28


**KH
      Funding Company**




Statements
      of Operations for the years ended December 31,




**2007**
            
            **2006****Interest
                Income**Interest
                and fees on loans
            
            $
            6,004,398
            
            $
            5,983,972Interest
                on bank accounts
            
            
            5,810
            
            
            129,314Interest
                on investments-marketable securities
            
            
            25,267
            
            
            30,966Total
                interest income
            
            
            6,035,475
            
            
            6,144,252**Interest
                Expense**Interest
                and fees on notes
            
            
            4,144,889
            
            
            4,041,679Interest
                on other loans
            
            
            192,467Interest
                on participation loans
            
            
            717
            
            
            -Total
                interest expense
            
            
            4,338,073
            
            
            4,041,679Net
                interest income
            
            
            1,697,402
            
            
            2,102,573**Provision
                for Loan Losses**
            
            
            510,185
            
            
            312,858Net
                interest income after provision for loan losses
            
            
            1,187,217
            
            
            1,789,715**Non-interest
                (Loss) Income**Rental
                income
            
            
            67,947
            
            
            55,822Loss
                on sale of real estate owned
            
            
            (20,736
            )
            
            (156,482
            )Loss
                on sale of securities
            
            
            (52,567
            )
            
            2,500Impairment
                of investment held for sale
            
            
            (25,436
            )Other
            
            
            13,706
            
            
            19,853Total
                non-interest loss
            
            
            (17,086
            )
            
            (78,307
            )**Non-interest
                Expense**Salaries
                and wages
            
            
            475,123
            
            
            450,970Professional
                fees
            
            
            206,773
            
            
            218,541Offering
                costs
            
            
            156,368
            
            
            223,697Administration
            
            
            104,865
            
            
            81,656Real
                estate maintenance
            
            
            110,161
            
            
            76,748Insurance
            
            
            77,033
            
            
            75,739Depreciation
            
            
            60,471
            
            
            59,062Rent
            
            
            115,164
            
            
            118,359Bank
                Charges
            
            
            48,723
            
            
            31,290Impairment
                of real estate held for sale
            
            
            60,000
            
            
            155,659Other
            
            
            19,975
            
            
            59,119Total
                non-interest expense
            
            
            1,434,656
            
            
            1,550,840**Net
                (Loss) Income**
            
            **$**
            (264,525
            )
            **$**
            **160,568**Basic
                earnings (loss) per share
            
            $
            (0.10
            )
            $
            0.06Diluted
                earnings (loss) per share
            
            $
            (0.10
            )
            $
            0.06Cash
                dividends paid per common share
            
            $
            0.04
            
            $
            0.08




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





29


**KH
      Funding Company**





Statements
      of Changes in Stockholders’ Equity


For
      the
      years ended December 31, 2007 and 2006


**Common Stock**
              
              **Paid-in**
              
              **Accumulated**
              
              **Subscription**
                **Note**
              
              **Accumulated**
                **Other**
                **Comprehensive**
              
              **Total**
                **Stockholders’****Shares**
              
              **Amount**
              
              **Capital**
              
              **Deficit**
              
              **Receivable**
              
              **(Loss) Income**
              
              **Equity****Balance
                  at January 1, 2006**
              
              
              2,555,556
              
              
              25,556
              
              
              1,603,852
              
              
              (429,688
              )
              
              (185,450
              )
              
              (99,463
              )
              
              914,807**Additional
                  Stock Sold**
              
              
              121,495
              
              
              1,214
              
              
              363,270
              
              
              
              
              
              
              
              
              
              
              
              364,484**Stock
                  Redemptions**
              
              
              (3,000
              )
              
              (30
              )
              
              (7,170
              )
              
              
              
              
              
              
              
              
              
              
              (7,200
              )**Stock
                  Options Exercised**
              
              
              40,000
              
              
              400
              
              
              79,600
              
              
              
              
              
              
              
              
              
              
              
              80,000**Stock
                  Issued to Board Members and Employees for
                  Services**
              
              
              12,900
              
              
              129
              
              
              38,571
              
              
              
              
              
              
              
              
              
              
              
              38,700**Stock-based
                  compensation expense**
              
              
              
              
              
              
              
              
              16,000
              
              
              
              
              
              
              
              
              
              
              
              16,000**Dividends
                  Declared $.08 per share**
              
              
              
              
              
              
              
              
              (214,340
              )
              
              
              
              
              
              
              
              
              
              
              (214,340
              )**Comprehensive
                  Income**Net
                  income for the year ended December 31, 2006
              
              
              
              
              
              
              
              
              
              
              
              160,568
              
              
              
              
              
              
              
              
              160,568Change
                  in fair value of investments
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              65,295
              
              
              65,295**Total
                  Comprehensive Income**
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              225,863**Balance
                  at December 31, 2006**
              
              
              2,726,951
              
              $
              27,269
              
              $
              1,879,783
              
              $
              (269,120
              )
              $
              (185,450
              )
              $
              (34,168
              )
              $
              1,418,314**Additional
                  Stock Sold**
              
              
              330
              
              
              4
              
              
              856
              
              
              
              
              
              
              
              
              
              
              
              860**Stock
                  Redemptions**
              
              
              (2,300
              )
              
              (23
              )
              
              (4,577
              )
              
              
              
              
              
              
              
              
              
              
              (4,600
              )**Stock
                  Based Compensation Expense**
              
              
              
              
              
              
              
              
              18,878
              
              
              
              
              
              
              
              
              
              
              
              18,878**Dividends
                  Paid $0.04 per share**
              
              
              
              
              
              
              
              
              (164,029
              )
              
              
              
              
              
              
              
              
              
              
              (164,029
              )**Comprehensive
                  Loss**Net
                  loss for the year ended December 31, 2007
              
              
              
              
              
              
              
              
              
              
              
              (264,525
              )
              
              
              
              
              
              
              
              (264,525
              )Change
                  in fair value of investments
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              34,168
              
              
              34,168**Total
                  Comprehensive Loss**
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (230,357
              )**Balance
                  at December 31, 2007**
              
              
              2,724,981
              
              
              27,250
              
              
              1,730,911
              
              
              (533,645
              )
              
              (185,450
              )
              
              0
              
              
              1,039,066




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





30


**KH
      Funding Company**





Statements
      of Cash Flows


For
      the
      years ended December 31,





**2007**
            
            **2006****Cash
                from Operating Activities:**Net
                (loss) income
            
            $
            (264,525
            )
            $
            160,568**Adjustments
                to reconcile net income to net cash from operating
                activities:**Depreciation
            
            
            60,471
            
            
            59,063Amortization
                of loan fees
            
            
            (122,718
            )
            
            (175,234
            )Provision
                for loan losses
            
            
            510,185
            
            
            312,858Share-based
                compensation expense
            
            
            18,878
            
            
            54,700Loss
                on sale of securities and property and equipment
            
            
            52,567
            
            
            (2,500
            )Loss
                on sale of real estate owned
            
            
            20,736
            
            
            156,482Impairment
                of real estate held for sale
            
            
            60,000
            
            
            155,659Loss
                on impairment of investments
            
            
            25,436
            
            
            -**Changes
                in operating assets and liabilities:**Accrued
                late charges
            
            
            (10,052
            )
            
            (22,955
            )Prepaid
                expenses
            
            
            907
            
            
            (178,135
            )Interest
                receivable
            
            
            (796,598
            )
            
            (550,182
            )Interest
                payable (included in notes payable)
            
            
            2,005,603
            
            
            1,960,572Accounts
                payable and accrued expenses
            
            
            32,237
            
            
            (2,140
            )Accrued
                Interest on investments
            
            
            -
            
            
            (6,077
            )Decrease
                in prepaid offering costs
            
            
            85,040
            
            
            258,401Deferred
                loan origination costs
            
            
            7,174
            
            
            (16,862
            )Unamortized
                brokerage fees
            
            
            31,448
            
            
            (35,559
            )Long
                term lease liability
            
            
            14,453
            
            
            21,390Prepaid
                loan expenses
            
            
            78,940
            
            
            (223,314
            )**Net
                Cash provided by Operating Activities**
            
            
            1,810,182
            
            
            1,926,735**Cash
                Flows from Investing Activities:**Principal
                repayments from borrowers
            
            
            17,091,098
            
            
            26,060,326Loans
                made to borrowers
            
            
            (11,524,219
            )
            
            (31,651,635
            )Purchase
                of loans
            
            
            (888,500
            )
            
            (8,633,400
            )Purchase
                of marketable securities and other investments
            
            
            -
            
            
            82,755Payments
                related to real estate owned (purchases and improvements)
            
            
            (11,135
            )
            
            (490,598
            )Proceeds
                from sale of marketable securities and other investments
            
            
            562,750
            
            
            -Proceeds
                (payments) for other receivables
            
            
            594,085
            
            
            (440,536
            )Purchase
                of property and equipment, net
            
            
            (41,888
            )
            
            (39,541
            )Proceeds
                from sale of real estate owned
            
            
            485,258
            
            
            143,927**Net
                Cash Provided (Used) by Investing Activities**
            
            
            6,267,449
            
            
            (14,968,702
            )**Cash
                Flow from Financing Activities:**Proceeds
                from investor notes
            
            
            2,321,330
            
            
            106,101,789Principal
                payments on investor notes
            
            
            (14,912,760
            )
            
            (95,933,794
            )Proceeds
                from other loans payable
            
            
            24,643,643
            
            
            -Payments
                on other loans payable
            
            
            (23,941,549
            )Proceeds
                from sales of common stock
            
            
            860
            
            
            444,484Increase
                in participation loans
            
            
            261,765
            
            
            -Payment
                of dividends
            
            
            (164,029
            )
            
            (214,340
            )Redemption
                of common stock
            
            
            (4,600
            )
            
            (7,200
            )Decrease
                in escrow and security deposits payable
            
            
            (9,682
            )
            
            (105,201
            )**Net
                Cash (Used) Provided by Financing Activities**
            
            
            (11,805,022
            )
            
            10,285,738**Net
                (Decrease) Increase in Cash**
            
            
            (3,727,391
            )
            
            (2,756,229
            )**Cash
                Balance**,
                beginning of year
            
            
            3,823,013
            
            
            6,579,242**Cash
                Balance**,
                end of year
            
            $
            95,622
            
            $
            3,823,013**Supplemental
                cash flows information:**Interest
                paid
            
            $
            4,030,905
            
            $
            2,081,077Transfer
                of loans to other real estate owned
            
            $
            1,676,922
            
            $
            325,137





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





31


**KH
      Funding Company**





Notes
      to
      Financial Statements


*For
      the Years Ended December 31, 2007 and 2006*




**NOTE
      A—SUMMARY OF SIGNIFICANT POLICIES**




***Nature
      of Operation***




KH
      Funding Company (the “Company”) operated as a general partnership from its
      founding in December 1990 until July 1, 1994, at which date it incorporated.
      The
      Company is an authorized mortgage lender in the State of Maryland, and provides
      lending services in the Washington, DC and Baltimore, MD metropolitan areas,
      primarily to small businesses and individuals and also purchases mortgage loans
      nationwide. The lending services the Company provides include originating,
      buying and selling loans and servicing its loans in house.




***Use
      of Estimates in Preparing Financial Statements***




In
      preparing financial statements in conformity with U.S. generally accepted
      accounting principles, 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.




***Reclassification***




Certain
      amounts have been reclassified in the 2006 financial statements to conform
      with
      the 2007 presentation.




***Investments
      Available for Sale***




Most
      of
      the Company’s investments are considered available for sale instruments and are
      recorded in compliance with Statement of Financial Accounting Standards (SFAS)
      No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The
      cost of securities sold is determined by the specific identification method.
      Purchase premiums and discounts are recognized in interest income using the
      interest method over the term of the securities. Net unrealized holding gains
      and losses are reported as accumulated other comprehensive income, a separate
      component of stockholders’ equity. Declines in the fair value of individual
      available-for-sale securities below their cost that are other than temporary
      result in a write-down of the individual security to its fair market value;
      write-downs are reflected in earnings as a realized loss on available-for-sale
      securities. Factors affecting the determination of whether an
      other-than-temporary impairment has occurred include a downgrading of the
      security by a rating agency, a significant deterioration in the financial
      condition of the issuer, or that management would not have the intent or ability
      to hold a security for a period of time sufficient to allow for any anticipated
      recovery in fair value.




***Loans
      Receivable and Allowance for Loan Losses***





Loans
      receivable are stated as unpaid principal balance net of any discounts,
      premiums, unamortized deferred fees and payments in process, less the allowance
      for loan losses.





Interest
      income from loans receivable is recognized using the interest method whereby
      interest income is recognized based upon the effective rate based upon
      outstanding principal. Loan origination fees received from borrowers are
      deferred and amortized into income over the established average life of related
      loan under a method which approximates the effective interest rate method.
      Loan
      premiums and discounts are also amortized into interest income under the same
      method.





The
      Company pays fees to third parties in connection with the acquisition of loans.
      These costs are amortized against interest income over the estimated average
      life of the loans under a method which approximates the effective interest
      rate
      method.





The
      Company incurs direct loan origination costs in its direct lending activities.
      It also incurs direct costs when it acquires loans. These direct costs are
      capitalized and amortized against interest income over the estimated average
      life of the loans under a method which approximates the effective interest
      rate
      method.





The
      allowance for loan losses is increased for charges to income and decreased
      for
      charge-offs (net of recoveries). Management’s periodic evaluation of the
      adequacy of the allowance is based on the Company’s past loan loss experience,
      known or inherent risks in the portfolio, adverse situations which may affect
      the borrower’s ability to repay, the estimated value of underlying collateral
      and current economic conditions. It is reasonably possible that the Company’s
      allowance for loan losses could change in the near term.




32




The
      allowance for loan losses is the result of an estimation done pursuant to either
      Statement of Financial Accounting Standards (“SFAS”) No. 5, *Accounting
      for Contingencies,* or SFAS
      No. 114, *Accounting
      by Creditors for Impairment of a Loan.* The
      allowance consists of a specifically allocated component and a general
      unallocated component.





The
      specific allowances are established in cases in which management has identified
      significant conditions or circumstances related to a loan that leads management
      to believe the probability that a loss may be incurred in an amount different
      from the amount determined by general allowance calculation described
      below.





The
      general unallocated component of the allowance is calculated by applying loss
      factors to corresponding categories of outstanding homogenous loans in an
      attempt to reduce the difference between estimated losses inherent in the
      portfolio and observed losses. The Company originates loans for various loan
      categories to include 1 st Trust
      Real Estate, 2 nd Trust
      Real Estate, Investment, Business Assets, etc. Each category has a specific
      percentage loss history for the past five years. Based on this percentage loss
      history, the Company reserves a similar percentage for the current balance
      of
      loans by category. These percentages, quantified in dollar amounts, comprise
      our
      general allowance for loan losses. Environmental factors are also considered
      in
      the calculation but are not a material component of the allowance.





Loans
      that are delinquent for more than three months are evaluated for collectibility
      and placed in non-accrual status when management determines that future earnings
      on that loan may be impaired. While in non-accrual status, collections on loans,
      if any, are recorded as collection of loan principal and no interest is
      recorded.




***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 if it is probable that the company will not collect
      all
      principal and interest payments according to the loan’s contractual 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.




***Property
      and Equipment***




Property
      and equipment are stated at cost and depreciated over the estimated useful
      lives
      of three to 30 years, primarily using the straight-line method for financial
      statement purposes.





***Real
      Estate Owned***




Real
      estate owned represents property acquired by foreclosure, deed in lieu of
      foreclosure or purchase and is initially recorded at the lower of cost or fair
      market value at the date of acquisition. In order to determine the fair value,
      we obtain an opinion of value from a licensed real estate professional. The
      difference between cost and fair value at the time of foreclosure is charged
      to
      the allowance for loan losses. Subsequent impairment of value is charged to
      operations. Costs relating to the improvements of the property are capitalized.
      Holding costs are charged to expense as incurred. Subsequent to the foreclosure
      the property is advertised for rent or sale. Management makes the determination
      of whether to hold, rent or to sell the property on a case-by-case basis.
      Buildings held for rental are depreciated over 30.5 years. Real estate owned
      which is held for sale is not depreciated. Impairment changes are recognized
      when the fair value of the property falls below its carrying value.




***Notes
      Payable***




We
      offer
      several different types of investor notes to our investors. Some notes are
      sold
      directly by us and many are sold through brokers. When brokers are involved,
      the
      Company pays brokerage fees which it capitalizes and amortizes into interest
      expense over the life of related notes.




***Income
      Taxes***




The
      Company has elected under Subchapter S of the Internal Revenue Code to be
      treated as an S Corporation for tax purposes, and accordingly, items of income
      and loss are taxed to the stockholders. Therefore, no provision for income
      taxes
      is necessary in the financial statements.




33


***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. For this calculation the effect of 150,000 options
      have been excluded for 2006, as their effect would be antidilutive. For 2007,
      all 241,250 options have been excluded because they would be antidilutive given
      the net loss in that year.




**Year Ended December 31,****2007**
            
            **2006**Basic
                :Net
                (loss) income (attributable to common stock)
            
            $
            (264,525
            )
            $
            160,568Average
                common shares outstanding
            
            
            2,726,210
            
            
            2,684,454Basic
                earnings (loss) per share
            
            $
            (0.10
            )
            $
            0.06Diluted
                :Net
                (loss) income (attributable to common stock)
            
            $
            (264,525
            )
            $
            160,568Average
                common shares outstanding
            
            
            2,726,210
            
            
            2,684,454Dilutive
                effect of stock options
            
            
            -
            
            
            101,892Average
                common shares outstanding - diluted
            
            
            2,726,210
            
            
            2,786,346Diluted
                earnings (loss) per share
            
            $
            (0.10
            )
            $
            0.06




***Stock
      Based Compensation***





Effective
      January 1, 2006, the Company adopted the fair value recognition provisions
      of
      SFAS No. 123(R), *Share-Based
      Payment,* (“SFAS
      123(R)”) using the prospective method as the standard. Because the Company’s
      shares are not publicly traded, we used the Minimum Value Method to value our
      stock-based compensation. Under that method, we will recognize as compensation
      expense over the service (or vesting) period of the grantees. In addition,
      at
      January 1, 2006, the adoption date of SFAS 123(R), the Company had no unvested
      options outstanding.





***Comprehensive
      Income***




Comprehensive
      income includes all changes in stockholders’ equity during a period, except
      those relating to investments by and distributions to stockholders. Our
      comprehensive income consists of net earnings and unrealized gains and losses
      on
      investments available-for-sale. Accumulated other comprehensive income is
      displayed as a separate component of stockholders’ equity.




**NOTE
      B – GOING CONCERN**




The
      accompanying financial statements have been prepared by the Company in
      accordance with the accounting principles generally accepted in the United
      States of America, which contemplate continuation of the Company as a going
      concern. In June 2006, the Company filed with the Securities and Exchange
      Commission (the “SEC”) and with several state securities regulators a
      registration statement covering an aggregate of $250,000,000 of Series 3 and
      Series 4 investor notes. This registration statement was declared effective
      by
      the SEC, but has not yet been declared effective by the Division of Securities
      of the Office of the Maryland Attorney General (the “Maryland Securities
      Division”). On January 23, 2008, the Company filed an amendment to this
      registration statement to update it and so that the Company could renew its
      investor note selling efforts. Again, although this amendment was declared
      effective by the SEC, the Maryland Securities Division has not yet declared
      this
      amendment effective. Until the Maryland Securities Division declares this
      amendment effective, the Company is unable to sell any of these investor notes
      from Maryland or to any Maryland resident. Because the Company’s sale of
      investor notes is largely dependent on its ability to offer them from Maryland
      and/or to Maryland residents, this registration delay presents a significant
      risk that the Company may have difficulty meeting, or even the inability to
      meet, its future liquidity needs. The Company requires cash to make and acquire
      loans, redeem outstanding investor notes, and pay other operational expenses.
      During 2007, the Company’s cash receivables from loan repayments—unscheduled
      prepayments and payments at maturity ($17.1 million)—exceeded its net investor
      note redemptions ($12.6 million) by approximately $4.5 million. Although the
      Company anticipates that it will continue to receive unscheduled and scheduled
      loan payments on a going-forward basis, there can be no guaranty that income
      generated from loans in the future will exceed the amounts needed to fund
      redemption requests and pay other operational expenses. Additionally,
      stockholders’ equity at December 31, 2007 has decreased to 1.95% of total
      assets, which the Company believes to be inadequate to fully protect it against
      potential losses. Accordingly, because both future income from loans and cash
      needed for operations, including investor note redemptions, are uncertain and
      because the Company cannot predict when, if at all, its amended registration
      will be declared effective in Maryland, there is substantial doubt about the
      Company’s ability to continue as a going concern.




34




Management
      is diligently working with the Maryland Securities Division to ensure that
      its
      amended registration statement is declared effective so that it may sell its
      investor notes from Maryland and to Maryland residents. Until such approval
      is
      obtained, management intends to carefully monitor and manage the Company’s
      assets and liquidity needs.





**NOTE
      C—INVESTMENT SECURITIES - AVAILABLE FOR SALE**




As
      of
      December 31, 2007, the Company had no marketable securities. However, securities
      available for sale consists of the following at December 31, 2006:


2006Gross
              
              GrossAmortized
              
              Unrealized
              
              Unrealized
              
              EstimatedCost
              
              Gains
              
              Losses
              
              Fair
                  ValueCorporate
                  Bonds (net of premiums)
              
              $
              615,317
              
              $
              -
              
              $
              (34,168
              )
              $
              581,149Other
              
              
              -
              
              
              -
              
              
              -Totals
              
              $
              615,317
              
              $
              -
              
              $
              (34,168
              )
              $
              581,149




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





**NOTE
      D—OTHER INVESTMENTS**




The
      Company has invested excess funds in several development stage companies.
      Because the Company maintains a minority position in these investments and
      cannot exert control the investments are accounted for under the cost method
      of
      accounting whereby only cash transactions effect the carrying value. There
      is no
      readily determinable market value for these investments. Management periodically
      reviews their status to determine if there has been any impairment to their
      value.




During
      2007, an additional write down of the remaining investment reduced the carrying
      value at December 31, 2007 by $25,436.




The
      carrying value of Other Investments, consisting of one investment, was $25,437
      and $50,872 at December 31, 2007 and 2006, respectively.




**NOTE
      E—LOANS RECEIVABLE**




Loans
      receivable consist of 187 collateralized loans and seven uncollateralized loans
      for 2007, and 220 collateralized loans and nine uncollateralized loans for
      2006.
      The loans receivable originate from various individuals and businesses ranging
      in balance from $1,199 to $3,648,645 for 2007 and $599 to $2,718,081 for 2006,
      bearing interest rates ranging from 3.99% to 24% in 2007 and from 3.99% to
      24%
      in 2006, with a weighted-average yield of 10.65% and 11.05%, respectively.
      Uncollateralized loans constitute approximately 0.4% of the gross loan value
      at
      December 31, 2007 and 2006.




Loan
      origination fees received from borrowers are deferred and amortized into
      interest income over the estimated average life of the loans under a method
      which approximates the effective interest rate method. The unamortized loan
      origination fees, which are included as a reduction to loans receivable balance,
      were $57,670 and $180,388 at December 31, 2007 and 2006,
      respectively.




The
      Company pays fees to third parties in connection with the acquisition of loans.
      These costs are amortized against interest income over the estimated average
      life of the loans under a method which approximates the effective interest
      rate
      method. Unamortized costs were $309,147 and $388,089 at December 31, 2007 and
      2006, respectively.




The
      Company incurs direct loan origination costs in its lending activities. These
      costs are capitalized and amortized against interest income over the estimated
      average life of the loans under a method which approximates the effective
      interest rate method. Unamortized direct loan origination costs were $33,677
      and
      $44,796 at December 31, 2007 and 2006, respectively.




35


***Loans
      Receivable by Collateral Type***




The
      Company’s loans receivable portfolio at December 31 consists of the following
      loans:





**2007**
            
            **2006****Primary
                Collateral Type**
            
            **Amount**
            
            **Amount**Residential
                Real Estate First Trust
            
            $
            11,441,120
            
            $
            15,403,919Business
                Assets and Commercial Real Estate First Trust
            
            
            3,049,002
            
            
            2,948,930Residential
                Investment Property First Trust
            
            
            30,711,891
            
            
            33,023,531Residential
                Real Estate Second Trust
            
            
            750,253
            
            
            1,153,487Other
                Assets (Auto, Stock)
            
            
            1,719,596
            
            
            1,978,712Other
                Loans (Over Equity, Medical and Unsecured)
            
            
            417,008
            
            
            407,751Total
                loans receivable, gross
            
            
            48,088,870
            
            
            54,916,330Unearned
                fees and other
            
            
            291,798
            
            
            239,844Less
                allowance for loan losses
            
            
            (495,480
            )
            
            (452,154
            )Total
                loans receivable, net
            
            $
            47,885,188
            
            $
            54,704,020




Loan
      maturities as of December 31, 2007 are as follows:




**Year
                Ending December 31,**2008
            
            $
            31,964,5592009
            
            
            1,882,5162010
            
            
            1,935,2022011
            
            
            3,958,9562012
            
            
            130,8562013
                and thereafter
            
            
            8,216,781Total
                loans receivable, gross
            
            $
            48,088,870




The
      fair
      value of the gross loans receivable is estimated to be $48,397,430 and
      $54,885,547 at December 31, 2007 and 2006, respectively. These estimates are
      based on discounted cash flows using the year end average interest for loans,
      assuming a mid-year pay-off of such loan in the year due.




At
      December 31, 2007, the Company had outstanding loan balances to one borrower
      and
      her affiliated entities in the aggregate amount of $9,979,364, which represented
      20.75% of loans outstanding at that date. Approximately $401,000 of these loans
      is unsecured, $5,705,000 is secured by first or second mortgages on 10 apartment
      buildings in Baltimore, Maryland, a first mortgage on a residential property
      in
      Woodbine, Maryland, the shares of Company common stock and Company investment
      accounts owned by the borrowers, $224,862 is secured by shares of Company common
      stock, and $3,648,645 is secured by a second lien on commercial property in
      Langley Park, Maryland. Management believes that this concentration is
      adequately collateralized based on current appraisals.




The
      Company issues lines-of-credit or draw-type loans. At December 31, 2007, the
      Company had $6.30 million in loans of this type. The unused or unfunded amount
      on these types of loans totaled $ .98 million at that date. This amount
      represents approved loan dollars which borrowers may use at their
      discretion.





***Analysis
      of Loan Loss Reserves***




Analysis
      of the allowance for loan loss is as follows:





**Year
                Ending December 31,**
            
            **2007**
            
            **2006**Beginning
                balance
            
            $
            452,154
            
            $
            369,791Provision
                for loan losses
            
            
            510,185
            
            
            312,858Loans
                charged off
            
            
            (466,859
            )
            
            (230,495
            )Recovery
                of loans previously charged off
            
            
            -
            
            
            -Ending
                balance
            
            $
            495,480
            
            $
            452,154




36




Loans
      in
      non-accrual status totaled $510,697 and $651,895 at December 31, 2007 and 2006,
      respectively.




At
      December 31, 2007 and 2006, the Company had loans of $5,002,259 and $1,748,342,
      respectively, which were more than 90 days late and for which the Company
      continues to accrue interest. Management believes that these loans are
      adequately collateralized and that both the principal and the related accrued
      interest are collectible.




**12/31/07**
            
            **12/31/06**Total
                recorded investment in impaired loans at the end of the
                period
            
            $
            510,697
            
            $
            651,895Amount
                of that recorded investment for which there is a related allowance
                for
                credit losses
            
            $
            510,697
            
            $
            631,289Amount
                of related allowance for credit losses associated with such
                investment
            
            $
            306,815
            
            $
            285,316Amount
                of that recorded investment for which there is no related allowance
                for
                credit losses
            
            $
            -
            
            $
            20,606





**12/31/07**
            
            **12/31/06**The
                average recorded investment in impaired loans during the
                period
            
            $
            581,296
            
            $
            744,142The
                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
      F—PROPERTY AND EQUIPMENT**




Property
      and equipment consists of the following as of December 31:





**2007**
            
            **2006**Furniture
                and equipment
            
            $
            84,335
            
            $
            84,335Automobiles
            
            
            61,516
            
            
            26,671Computer
                software
            
            
            101,022
            
            
            93,979Leasehold
                improvements
            
            
            18,813
            
            
            18,813Total
                property and equipment-cost
            
            
            265,686
            
            
            223,798Less:
                Accumulated depreciation
            
            
            123,693
            
            
            80,379Property
                and equipment - net
            
            $
            141,993
            
            $
            143,419




Depreciation
      expense related to property and equipment for the years ended December 31,
      2007
      and 2006, totaled $43,314 and $36,245, respectively.





**NOTE
      G—REAL ESTATE OWNED**




Real
      estate owned currently consists of rental and held for sale real
      estate.





**2007**
            
            **2006**Rental
                property:Buildings
            
            $
            436,269
            
            $
            550,686Less:
                Accumulated Depreciation
            
            
            51,910
            
            
            46,375384,359
            
            
            504,311Land-rental
                property
            
            
            291,555
            
            
            310,130Total
                rental
            
            $
            675,914
            
            $
            814,441Held
                for Sale:Buildings
            
            $
            1,065,405
            
            $
            264,473Land
            
            
            503,250
            
            
            60,750Total
                held for sale
            
            $
            1,568,655
            
            $
            325,223




Depreciation
      expense related to rental property for the years ended December 31, 2007 and
      2006 totaled $17,157 and $22,817, respectively.





37


**NOTE
      H—NOTES PAYABLE, INTEREST EXPENSE AND TYPES OF NOTES**




Information
      related to investor notes payable at December 31, 2007 and 2006 is as
      follows:





**2007**
            
            **2006**Number
                of notes payable
            
            
            1,345
            
            
            1,876Highest
                balance
            
            $
            2,992,200
            
            $
            1,997,804Lowest
                balance
            
            $
            1
            
            $
            8Lowest
                interest rate
            
            
            5.25
            %
            
            4.00
            %Highest
                interest rate
            
            
            9.15
            %
            
            9.15
            %Weighted
                average interest rate
            
            
            7.26
            %
            
            6.53
            %Number
                of accounts greater than $100,000
            
            
            106
            
            
            137Value
                of accounts over $100,000
            
            $
            29,193,921
            
            $
            33,732,440




The
      carrying values of the notes payable approximate their fair value.





The
      maturity date of the notes payable are as follows:




**Year
                Ending December 31,**2008
            
            
            35,586,6762009
            
            
            5,022,9242010
            
            
            3,424,3692011
            
            
            3,949,7512012
            
            
            3,316,4032013
            
            
            51,372Subtotal
            
            
            51,351,495Unamortized
                brokerage costs
            
            
            (131,532
            )Total
                Notes and accrued interest payable
            
            $
            51,219,963




The
      maturity date is considered to be the date on which the note first becomes
      a
      demand note. Included in the due in 2008 category is $7,519,915 on one-day
      demand notes, which the investor can immediately withdraw and $13,861,052 that
      requires a 30 days notice before withdrawal can be made.





The
      Company has three classes of notes payable—Series 2, 3 and 4 notes. Series 2
      notes were sold in private offerings by the Company from inception through
      November 2, 2003. Series 3 and 4 notes were offered and sold pursuant to
      registration statements filed by the Company with the SEC. The Series 3 notes
      are senior to all other debt of the Company and are secured with a priority
      lien
      on the assets of the Company. The Series 4 notes join the Series 2 notes in
      right of payment and both are subordinate to senior debt of the
      Company.




As
      of
      December 31, 2007, notes payable outstanding by class of securities is as
      follows:




Series
                II
            
            
            Privately
                issued subordinated debt
            
            $
            -Series
                III
            
            
            Publicly
                issued senior debt
            
            
            44,488,976Series
                IV
            
            
            Publicly
                issued subordinated debt
            
            
            6,862,519Subtotal
            
            
            
            
            
            51,351,495Unamortized
                brokerage costs
            
            
            
            
            
            (131,532
            )Total
                Notes and accrued interest payable
            
            
            
            
            $
            51,219,963




The
      Company’s notes are sold directly by the Company and through brokers. For those
      notes sold through brokers, the Company pays brokerage fees which it capitalizes
      and amortizes into interest expense over the life of the related notes. The
      unamortized brokerage costs were $131,532 and $162,981 at December 31, 2007
      and
      2006, respectively.




For
      the
      year ended December 31, 2007 and 2006, interest expense totaled $4,338,073
      and
      $4,041,679, respectively, and interest paid totaled $4,030,905 and $2,081,077,
      respectively.




38


**NOTE
      I—RELATED PARTY TRANSACTIONS**




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




·
            Included
                in loans receivable at December 31, 2007 and 2006 are 12 notes totaling
                $10,649,192 and 14 notes totaling $9,571,428, respectively, from
                officers,
                stockholders and entities controlled by a stockholder. The interest
                rates
                on these notes range from 5.99% to
                12.5%.




·
            Included
                in the notes payable at December 31, 2007 and 2006 are 66 notes totaling
                $11,437,449 and 63 notes totaling $7,421,423, respectively, which
                are held
                by officers and stockholders. These notes were all issued at the
                rate in
                effect for the applicable term selected as of the date each note
                was
                issued.




·
            There
                is a loan of $185,450, shown in the equity section of the Balance
                Sheet 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
                7%. The
                stock has a book value of about $49,000 and a fair value of approximately
                $200,000 as of December 31, 2007. At December 31, 2007 and 2006,
                all
                payments under this loan had been timely made and the there was no
                accrued
                interest receivable on this loan.




All
      of
      the above transactions were consummated on substantially the same terms,
      including interest rates and collateral, as those prevailing for comparable
      transactions with other customers.




Included
      in the notes receivable listed above are five loans in the aggregate amount
      of
      $9.75 million to a trust for the benefit of a significant stockholder. These
      loans were made during the year ended December 31, 2006. The proceeds of these
      loans were used to purchase real estate which serves as security for the loans.
      The Company holds a first or second lien position with respect to the collateral
      securing approximately $9.75 million of these loans as well as other real and
      personal collateral . The loans bear interest at 8% per annum and have some
      variable up-side features. Additional interest is earned on certain loans if
      the
      rental income the borrower receives from the property exceeds certain allowable
      expenses. In addition, upon the sale of certain the real property(ies) (or
      components thereof), the Company is to receive one quarter or one-half,
      depending on the specific property, of any gain after adjusting for certain
      costs and commissions. The loans do not have any variable down-side features
      which would cause interest to be lower than the stated rate on each loan. Under
      the terms of the loans any refinancing or sale of the properties must be
      approved by the Company in advance. During the year ended December 31, 2006,
      the
      Company recognized $80,445 in additional interest from the above loan features.
      The Company recognizes such additional interest earned through variable up-side
      loan features only when the additional interest is collected.





**NOTE
      J—WARRANTS, OPTIONS AND OTHER STOCK ISSUED**




***Stock
      Option Plans***




The
      Company has granted stock options to employees, stockholders and directors.
      Prior to 2006, all options granted vested on the day they were granted. All
      options granted in 2006 were issued under the 2005 Equity Incentive Plan. These
      options, which are incentive stock options, vest over three years in three
      equal
      annual installments.




In
      2006,
      options to purchase 100,000 shares of common stock were issued at $3.00 per
      share and options to purchase 50,000 shares were issued at $3.30 per share.
      In
      2006, 40,000 previously issued options were exercised at $2.00 per share, having
      an intrinsic value of $40,000 at that time. In 2007, 60,000 options expired
      and
      170,000 options were forfeited by a former employee. The following depicts
      option activity for the years ended December 31, 2007 and 2006:




**Number of**
              **Shares**
            
            **Weighted-Average**
              **Exercise Price**
            
            **Aggregate**
              **Intrinsic Value**Options
                outstanding at January 1, 2006
            
            
            361,250
            
            $
            2.07Options
                granted-2006
            
            
            150,000
            
            
            3.10Options
                expired-2006
            
            
            -
            
            
            -Options
                exercised-2006
            
            
            (40,000
            )
            
            2.00
            
            $
            40,000Options
                outstanding at December 31, 2006
            
            
            471,250
            
            
            2.40
            
            $
            282,750Options
                granted-2007
            
            
            -
            
            
            -Options
                expired or forfeited -2007
            
            
            230,000
            
            
            2.41Options
                exercised-2007
            
            
            -
            
            
            -Options
                outstanding at December 31, 2007
            
            
            241,250
            
            $
            2.39
            
            $
            -




39




At
      December 31, 2007, 187,917 of the Company’s outstanding options were
      exercisable. The weighted average exercise price of these options is $2.17
      and
      the weighted average remaining contractual life was two years. The remaining
      53,333 stock options vest over a period of three years and will be fully vested
      by July 11, 2011. The combined weighted average exercise price for the total
      241,250 options outstanding at December 31, 2007 was $2.39. Options to purchase
      80,000 shares were granted under the 2005 Incentive Stock Option Plan. All
      of
      the other options outstanding were granted outside of any stockholder approved
      stock option plan of the Company.




A
      summary
      of stock options outstanding and exercisable at December 31, 2007 by exercise
      price is as follows:





Weighted AverageRemainingNumber
            
            Contractual Life
            
            NumberExercise Price
            
            Outstanding
            
            ( in years)
            
            Exercisable$2.00
            
            
            161,250
            
            
            1.75
            
            
            161,250$3.00
            
            
            30,000
            
            
            3.54
            
            
            10,000$3.30
            
            
            50,000
            
            
            3.54
            
            
            16,667241,250
            
            
            
            
            
            187,917





The
      weighted fair value of options granted during December 31, 2006 was $0.61.
      No
      options were granted during 2007.





The
      fair
      value of options granted was calculated using the Black-Scholes option pricing
      model. The 150,000 options granted to employees in the year ended December
      31,
      2006 vest ratably each year over a three year period **.** Seventy
      thousand of these options were forfeited during 2007. The options vesting in
      2007 and 2006 gave rise to a $18,878 and $16,000 charge to income in these
      years, respectively. The amount of approximately $21,136 in future compensation
      costs for options outstanding will need to be recognized as these options vest
      in future periods. The weighted average and other assumptions used in the
      Black-Scholes model were during the year ended December 31, 2006 were as
      follows:





Dividend
                yield
            
            
            2.67
            %Weighted
                average volatility
            
            
            22.4
            %Weighted
                average risk-free interest rate
            
            
            5.03
            %Weighted
                average expected life in years
            
            
            5
                years




The
      value
      of stock granted to employees and to non-independent directors (for their Board
      service) for the year ended December 31, 2006 was $18,600 and 20,100,
      respectively, a total of $38,700. No stock was granted during 2007.





**NOTE
      K—NONLOAN COMMITMENTS AND CONTINGENCIES**




***Lease
      Commitment***




In
      October 2005, the Company expanded its office facilities to approximately twice
      the original size. A new 10-year lease, which will expire October 31, 2015,
      was
      signed at that time. The following is a schedule by years of approximate future
      minimum payments under the lease as of December 31, 2007:





**Year
                Ending December 31,**2008
            
            $
            102,4262009
            
            
            106,5222010
            
            
            110,7842011
            
            
            115,2082012
            
            
            119,822Thereafter
            
            
            365,780Total
            
            $
            920,542




Total
      rent expense under operating leases totaled $115,164 and $118,359 for the years
      ended December 31, 2007 and 2006, respectively.




**NOTE
      L—LOAN PARTICIPATION AND OFF BALANCE SHEET LOAN
      COMMITMENTS**





The
      Company entered into a loan participation agreement during 2007 pursuant to
      which it sold a $261,764 participation interest, with monthly interest only
      payments due to the participants.




40




Credit
      commitments are agreements make loans to borrowers in the ordinary course of
      business. The Company does not have such agreements. However, the Company does
      make line-of-credit type loans, which enable borrowers to draw down on their
      approved loans as needed. At December 31, 2007, the Company had $6.30 million
      in
      loans of this type. Loans of this type had unused or unfunded approved amount
      of
      $.98 million at that date.





**NOTE
      M— TRUST ACTIVITIES**




The
      Company became a trustee of IRA accounts in February 2003. The IRA accounts
      are
      self-directed. A portion of the assets under the trust have been invested in
      investor notes. As a trustee, the Company is subject to Section 1.408-2(e)
      of
      the Internal Revenue Code and is subject to reviews by IRS examiners. No such
      review occurred in 2004. The Company underwent a review in 2005 and is not
      aware
      of any issues resulting from such review.





**Year
                Ending December 31,**
            
            **2007**
            
            **2006**Total
                Assets under Trust
            
            $
            7,516,324
            
            $
            7,785,921Portion
                of Assets Invested in KH Funding Notes Payable
            
            $
            7,041,324
            
            $
            7,206,921Portion
                of Assets Invested in Outside Investments
            
            $
            475,000
            
            $
            579,000




**NOTE
      N — LOAN CONCENTRATIONS**




The
      Company makes loans to a number of different business and individuals; however,
      it does have a concentration of loans, directly or indirectly, with two of
      its
      stockholders. At December 31, 2007, the Company had approximately $9.75 million,
      or 21%, of its loans and interest receivable directly or indirectly with one
      stockholder an entity owned by that stockholder. The Company also purchases
      loans from a company owned by another stockholder. At December 31, 2006,
      approximately $11.80 million, or 21%, of the Company’s loans and interest
      receivable were loans of this type. During 2007, no loans were purchased from
      this source due to the inability of the Company to sell its investor notes
      and
      the resulting shortage of funds required to purchase loans. As is mentioned
      in
      Note H - Related Party Transactions, the above loans were consummated on
      substantially the same terms, including interest rates and collateral, as those
      prevailing for comparable transactions.




41


**ITEM
      8.**  **CHANGES
      IN AND DISAGREEMENTS WITH ACCOUNTANTS ON**  **ACCOUNTING
      AND FINANCIAL DISCLOSURE**




None.





**ITEM
      8A(T).**  **CONTROLS
      AND PROCEDURES** .





The
      Company maintains disclosure controls and procedures that are designed to ensure
      that information required to be disclosed in the Company’s reports filed under
      the Exchange Act with the Securities and Exchange Commission, such as this
      annual report, is recorded, processed, summarized and reported within the time
      periods specified in those rules and forms, and that such information is
      accumulated and communicated to the Company’s management, including the Chief
      Executive Officer, who also serves as the Company’s Chief Financial Officer
      (“CEO”), as appropriate, to allow for timely decisions regarding required
      disclosure. A control system, no matter how well conceived and operated, can
      provide only reasonable, not absolute, assurance that the objectives of the
      control system are met. Further, the design of a control system must reflect
      the
      fact that there are resource constraints, and the benefits of controls must
      be
      considered relative to their costs. These inherent limitations include the
      realities that judgments in decision-making can be faulty, and that breakdowns
      can occur because of simple error or mistake. Additionally, controls can be
      circumvented by the individual acts of some persons, by collusion of two or
      more
      people, or by management override of the control. The design of any system
      of
      controls also is based in part upon certain assumptions about the likelihood
      of
      future events, and there can be no assurance that any design will succeed in
      achieving its stated goals under all potential future conditions; over time,
      control may become inadequate because of changes in conditions, or the degree
      of
      compliance with the policies or procedures may deteriorate.





An
      evaluation of the effectiveness of these disclosure controls as of December
      31,
      2007 was carried out under the supervision and with the participation of the
      Company’s management, including the CEO. Based on that evaluation, the Company’s
      management, including the CEO, has concluded that the Company’s disclosure
      controls and procedures are, in fact, effective at the reasonable assurance
      level.





During
      the fourth quarter of 2007, there was no change in the Company’s internal
      control over financial reporting that has materially affected, or is reasonably
      likely to materially affect, the Company’s internal control over financial
      reporting.





As
      required by Section 404 of the Sarbanes-Oxley Act of 2002, management has
      performed an evaluation and testing of the Company’s internal control over
      financial reporting as of December 31, 2007. Management’s report on the
      Company’s internal control over financial reporting is included in Item 7 of
      this report and is incorporated herein by reference.





**ITEM
      8B. OTHER INFORMATION.**




None.





42


**PART
      III**





**ITEM
      9.**  **DIRECTORS,
      EXECUTIVE OFFICERS, PROMOTERS, CONTROL PERSONS AND CORPORATE GOVERNANCE;
      COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT**




**Directors
      and Executive Officers**





Our
      Board
      of Directors is currently made up of four directors, who are elected to annual
      terms and until their successors are elected and qualified. On February 13,
      2008, one director, Dr. Mervyn Feldman, died. The Board has not yet decided
      whether to elect a replacement or eliminate the vacancy by permanently reducing
      the number of directors to four. Executive officers are appointed by the Board
      of Directors on an annual basis and serve until their successors have been
      duly
      elected and qualified. There are no family relationships among any of our
      directors or executive officers.





The
      following table sets forth the names, ages and positions of our current
      directors and executive officers:





**Name**
            
            **Age**
            
            **Position(s)**Robert
                L. Harris
            
            58
            
            Chief
                Executive Officer, President, acting Chief Financial Officer and
                DirectorJames
                E. Parker
            
            59
            
            Vice
                PresidentLouise
                B. Sehman
            
            73
            
            SecretaryRonald
                L. Nicholson
            
            53
            
            Vice
                President-Accounts and Loan AdministrationJack
                H. Breskow
            
            78
            
            DirectorAlvin
                Shapiro
            
            76
            
            DirectorJeremiah
                P. Connor
            
            68
            
            Director




ROBERT
      L.
      HARRIS, age 58, was a founder of KH Funding Company in 1990 when he also began
      his service as Managing General Partner and then President. He has been the
      President, Chief Executive Officer and a director of KH Funding since its
      incorporation in 1994, and has served as interim Chief Financial Officer since
      October 5, 2007. Prior to founding KH Funding, Mr. Harris owned and operated
      businesses and managed commercial and corporate real estate for various firms
      in
      Maryland. He attended the Citadel Military College and Montgomery
      College.





JAMES
      E.
      PARKER, age 59, joined KH Funding Company in 1997 and serves as Vice President.
      Mr. Parker’s duties include serving as our office manager and providing
      accounting assistance. Mr. Parker has served as the Chief Financial Officer
      and
      Treasurer of KH Funding, as well as Vice President of Investor Relations and
      Trust Services. Mr. Parker was an assistant controller of a lumber and supply
      company before joining us. He earned a Bachelor of Science from the University
      of Maryland.





LOUISE
      B.
      SEHMAN, age 73, joined KH Funding Company in 1992. She currently serves as
      our
      Corporate Secretary and handles various bookkeeping functions. Ms. Sehman was
      a
      payroll supervisor for a convenience store chain before joining us. She attended
      the University of Maryland. Ms. Sehman retired as Chief Financial Officer and
      Treasurer effective March 31, 2006.





RONALD
      L.
      NICHOLSON, age 53, joined KH Funding Company in 1996. He currently serves as
      the
      Vice President of Accounts and Loan Administration. Mr. Nicholson’s duties
      include periodically reviewing loan accounts to ensure that our borrowers are
      complying with the conditions of their loans and assisting in the underwriting
      of new loans.





JACK
      H.
      BRESKOW, age 78, has served as a director of KH Funding Company since its
      incorporation in 1994. Mr. Breskow has served as Secretary of Jack H. Breskow
      and Associates, Ltd. since 1989, which provides business, estate and financial
      planning services to its clients. Since 1953, Mr. Breskow has also served as
      a
      registered representative of Lincoln Financial Advisors Corporation, a
      registered broker-dealer and investment adviser firm. He is a Certified Life
      Underwriter and Accredited Estate Planner.





ALVIN
      SHAPIRO, age 76, has served as a director of KH Funding Company since 2005.
      Mr.
      Shapiro has served as president of A & S Shapiro Pension Consultants,
      Inc., a third-party administrator of business pension plans, since 1997. Since
      1973, Mr. Shapiro has also served as a registered representative of Chapin
      Davis, Inc., a broker-dealer firm. He holds a Series 6 license and the insurance
      industry designations of CLU and CHFC. Mr. Shapiro received an MBA from John
      Hopkins University and a Bachelor of Science Degree in Finance from American
      College.





JEREMIAH
      P. CONNOR, age 68, has served as a director of KH Funding Company since 2005.
      Mr. Connor is currently a partner of Connor & Assoc. CPA’s, P.C. and has
      served with that firm since 1986. Mr. Connor is a Certified Public Accountant
      with over 35 years of accounting experience. Mr. Connor is a distinguished
      member of state and national CPA organizations. He graduated with a Bachelor
      of
      Commercial Science from Benjamin Franklin University .




43




DR.
      MERVYN FELDMAN, age 73, served as a director of KH Funding Company from
      1998 until his death on February 13, 2008.  Dr. Feldman maintained an
      active medical practice specializing in podiatry. He attended Wilson Teachers
      College and the Pennsylvania College of Podiatric Medicine.





**Compliance
      with Section 16(a) of the Exchange Act.**





Our
      equity securities are not registered under the Exchange Act and, accordingly,
      our directors, executive officers and significant stockholders are not required
      to file equity ownership reports pursuant to Section 16(a) of the Exchange
      Act.





**Board
      Committees**





The
      Board
      of Directors has a standing Audit Committee, whose members are Messrs. Connor
      and Shapiro (Chairperson). Until January 16, 2008, Mr. Harris also served on
      the
      Audit Committee. The Audit Committee is responsible for reviewing the audit
      policy and program and recommending any policy changes to the Board of
      Directors, and the appointing, replacing, compensating, and overseeing the
      Company’s independent registered public accounting firm each year. The Audit
      Committee meets with the external auditors, reviews all of our SEC filings,
      oversees our internal control structure and reports to the Board of Directors
      on
      the findings. During 2007, the Audit Committee met four times. The Board of
      Directors has adopted a written charter for the Audit Committee. **** The
      Board
      has determined that each of Messrs. Connor and Shapiro is an “audit committee
      financial expert” as that term is defined in Item 407(d)(5) of the SEC’s
      Regulation S-B.





Since
      we
      are a privately-held company, we are not required to have either a Nominations
      or a Compensation Committee. As a privately-held company with a board consisting
      of a majority of independent directors, we currently believe that the Board
      as a
      whole can adequately fulfill the responsibilities of a Nominations and
      Compensation committees. Our independent directors review and approve executive
      compensation policies and practices, review the salaries and the bonuses of
      the
      officers, including the Chief Executive Officer and Chief Financial Officer,
      and
      administer our stock option plan and other benefit plans. Our Chief Executive
      Officer provides input on the salaries of our other executive officers and
      employees. Should the circumstances change, the Board may form one or both
      of
      these committees in the future. Currently,





**Code
      of Ethics**





Our
      Board
      of Directors has adopted a Code of Ethics that applies to our directors and
      to
      all our executive officers, including without limitation, our principal
      executive officer and principal financial officer. A copy of our Code of Ethics
      is posted on our website, www.khfunding.com. In addition, a copy of our Code
      of
      Ethics will be provided without charge to any person upon request. Requests
      should be directed to our Corporate Secretary at KH Funding, 10801 Lockwood
      Drive, Suite 370, Silver Spring, Maryland 20901. You may also request a copy
      by
      calling us at (301) 592-8100.




44


**ITEM
      10.**  **EXECUTIVE
      COMPENSATION**





**Executive
      Compensation**





The
      following table sets forth the total remuneration for services in all capacities
      awarded to, earned by, or paid to our President and Chief Executive Officer,
      sometimes referred to in this prospectus as the “named executive officer” for
      each of the last two completed fiscal years. No other person who served as
      an
      executive officer during 2007 earned total compensation in excess of $100,000
      for 2007 (or would have earned in excess of such amount had they been an
      executive officer as of December 31, 2007). We do not maintain any non-equity
      incentive compensation, pension or other retirement, or non-qualified deferred
      compensation plans for our executive officers.





**SUMMARY
      COMPENSATION TABLE**




**Name
                and principal position**
            
            **Year**
            
            **Salary**
              **($)**
            
            **Bonus**
              **($)**
            
            **Stock
                Awards**
              **($)**
            
            **Option**
              **Awards**
              **($)
                (2)**
            
            **All
                Other Compensation**
              **($)**
            
            **Total**
              **($)**Robert
                L. Harris, President/CEO/CFO(1)
            
            
            2006
            
            
            123,900
            
            
            2,283
            
            
            0
            
            
            4,715
            
            
            0
            
            
            130,8982007
            
            
            132,291
            
            
            2,383
            
            
            0
            
            
            0
            
            
            0
            
            
            134,674






(1)
            Mr.
                Harris also serves as a director of KH Funding for which he receives
                standard director compensation as discussed above. However, he did not
                accept any director compensation in 2007 or
                2006.


(2)
            On
                July 10, 2006, Mr. Harris was granted an option to purchase 50,000
                shares
                of our common stock under our 2005 Incentive Stock Option Plan. The
                options have an exercise price of $3.30 per share, which equaled
                the
                estimated fair market value of the shares on the grant date-$3.00-
                plus a
                10% premium. The options vest in three equal annual installments
                commencing one year after the grant date and expire on July 10, 2011.
                The
                amount shown reflects the dollar amount recognized for financial
                statement
                reporting purposes for the fiscal year ended December 31, 2007 in
                accordance with FAS 123(R) of awards pursuant to the Plan. Assumptions
                used in the calculation of this amount are included in Note J to
                our
                audited financial statements for the fiscal year ended December 31,
                2007
                presented elsewhere in this report.





**Employment
      Arrangements**





Executive
      officers are employed on an at-will basis and are not parties to any written
      employment agreement. Our employment arrangements entitle the executive, while
      employed, to an annual salary and participation in the bonus, equity and other
      plans discussed above, as well as health, dental and life insurance programs
      in
      place for executives from time to time.





For
      2008,
      Mr. Harris is entitled to an annual salary of $132,291.





**Bonus
      Program**





All
      of
      our employees, including Mr. Harris, are entitled to an annual bonus equal
      to
      one-half of one week’s pay, based on their salary levels for that year.





**Equity
      Compensation Plans**





We
      maintain two equity compensation plans for executive officers and employees:
      (i)
      the 1998 Stock and Incentive Plan; and (ii) the 2005 Equity Incentive Plan.





The
      1998
      Stock and Incentive Plan was approved by the Board of Directors and its
      stockholders in 1998 and was replaced by the 2005 Equity Incentive Plan. The
      plan provided for the grant of incentive stock options, non-qualified stock
      options, stock appreciation rights, restricted stock, restricted stock units
      and/or performance units to key employees designated by the Board or its
      designated committee. Awards vested,
      were exercisable and terminated in accordance with the individual terms of
      the
      award agreements granting such awards. Awards could be payable in shares of
      our
      common stock, cash, or other securities, as determined by the Board and set
      forth in the award agreement. Awards were subject to adjustment and acceleration
      of vesting under certain specified conditions.




The
      2005
      Equity Incentive Plan was approved by the Board of Directors and our
      stockholders in 2005 and expires on January 27, 2015. The plan provides for
      the
      grant of incentive stock options to our officers and employees, and
      non-qualified stock options, stock bonus grants and/or restricted stock purchase
      grants to directors, officers, employees and consultants. Awards vest,
      are
      exercisable and terminate in accordance with the individual terms of the award
      agreements granting such awards. Awards are payable in shares of our common
      stock. Awards are subject to adjustment and acceleration of vesting under
      certain specified conditions. At adoption, we reserved 1,000,000 shares of
      common stock for future issuances under this plan.




45





T he
      following table sets forth for the named executive officer certain information
      about equity awards under all plans that remained unexercised at December 31,
      2007:





**OUTSTANDING
      EQUITY AWARDS AT FISCAL YEAR-END**


**OPTION
      AWARDS**





**Name**
            
            **Number of Securities**
              **Underlying Unexercised**
              **Options**
              **(#)**
              **Exercisable**
            
            **Number of Securities**
              **Underlying Unexercised**
              **Options**
              **(#)**
              **Unexercisable (1)**
            
            **Option Exercise Price**
              **($)**
            
            **Option Expiration Date**Robert Harris
            
            
            150,000
            
            
            0
            
            
            2.00
            
            
            9/30/200916,666
            
            
            33,334
            
            
            3.30
            
            
            7/10/2011




(1)  The
      options vest in two equal annual installments commencing on July 10,
      2008.




**Director
      Compensation**





The
      following table provides information about compensation paid to or earned by
      our
      directors during 2007 who are not also named executive officers (as defined
      below).





**Name**
            
            **Fees earned or**
              **paid in cash**
              **($)**
            
            **Stock Awards**
              **($)(1)**
            
            **Option Awards**
              **($)(2)**
            
            **Total**
              **($)**Jack
                H. Breskow
            
            
            900
            
            
            0
            
            
            0
            
            
            900Dr.
                Mervyn Feldman (deceased)
            
            
            0
            
            
            0
            
            
            0
            
            
            0Alvin
                Shapiro
            
            
            1,200
            
            
            0
            
            
            0
            
            
            1,200Jeremiah
                P. Connor
            
            
            4,000
            
            
            0
            
            
            0
            
            
            4,000




(1)
              Amounts
                  calculated using the provisions of Statement of Financial Accounting
                  Standards (“SFAS”) No. 123R, “Share-based Payments”. See Note A to the
                  audited financial statements under the heading “Stock Based Compensation”
                  contained elsewhere in this prospectus regarding assumptions underlying
                  valuation of equity awards.


(2)
              There
                  were no options outstanding for purchase of shares by the above
                  named
                  directors at December 31,
                  2007.





Directors
      receive a maximum of either (i) $300 or (ii) an outright grant of $300 worth
      of
      our common stock for each Board meeting attended. No additional fees are paid
      for attendance at any Committee meetings.





46


**ITEM
      11.**  **SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
      MATTERS**




The
      following table sets forth, to the best of our knowledge, information as of
      December 31, 2007 relating to the beneficial ownership of our common stock
      by
      (i) each person or group known by us to own beneficially more than five (5%)
      of
      the outstanding shares of our common stock; (ii) each of our directors, director
      nominees, and named executive officers (as defined below); and (iii) all of
      our
      directors and executive officers as a group, and includes all shares of our
      common stock that may be acquired within 60 days of December 31, 2007. The
      address of each of the persons named below is the address of KH Funding except
      as otherwise indicated. Such beneficial ownership includes securities owned
      by
      or for the spouse, children or certain other relatives of the identified persons
      as well as other securities as to which the person has or shares voting or
      investment power. The same shares may be beneficially owned by more than one
      person.


**Name**
              
              **Number of**
                **Shares**
              
              **Percent of Class**
                **as of December**
                **31, 2007****Directors
                  and Named Executive Officers**Robert
                  L. Harris, President, CEO and Director
              
              
              665,000
              (1)
              
              22.4
              %Jack
                  H. Breskow, Director
              
              
              39,700
              (2)
              
              1.3
              %Jeremiah
                  P. Connor, Director
              
              
              0
              
              
              0Dr.
                  Mervyn Feldman, Director (deceased)
              
              
              97,478
              (3)
              
              3.3
              %Alvin
                  Shapiro, Director
              
              
              600
              
              
              *All
                  Directors and Executive Officers as a Group (7 persons)
              
              
              802,778
              (4)
              
              27.0
              %**5%
                  Stockholders**Solomon
                  Kaspi
                267
                  Kentlands Blvd. Gaithersburg, MD
              
              
              167,168
              
              
              5.6
              %Christine
                  Nuyen
                267
                  Kentlands Blvd, Gaithersburg, MD
              
              
              166,666
              
              
              5.6
              %Carlos
                  Saenz
                267
                  Kentlands Blvd, Gaithersburg, MD
              
              
              166,666
              
              
              5.6
              %Richard
                  Allen
                7224
                  Armat Drive, Bethesda, MD
              
              
              165,000
              
              
              6.06
              %Douglas
                  Kelly
                11120
                  Arroyo Drive, Rockville, MD
              
              
              170,000
              
              
              6.24
              %Jin
                  S. Kim
                34
                  Piney Meetinghouse Ct, Potomac, MD
              
              
              516,700
              
              
              17.5
              %All
                  5% Stockholders as a group (6 persons)
              
              
              1,352,200
              
              
              45.6
              %**Total:
                  Directors, Executive Officers, and 5%
                  Stockholders**
              
              
              **2,154,978**
              
              
              72.7
              %




*
      Constitutes less than 1%


(1)
      Includes (i) 465,000 shares of common stock held directly and (ii) options
      to
      purchase 200,000 shares of common stock.


(2)
      Includes 37,500 shares of common stock held by spouse.


(3)
      Includes 95,778 shares of common stock held with spouse.


(4)
      Includes options to purchase 141,250 shares of common stock.





**ITEM
      12.**  **CERTAIN
      RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
      INDEPENDENCE**




**Related
      Party Transactions**





From
      time
      to time, in the ordinary course of our business, we enter into loan transactions
      (both as lender and borrower) with our directors and executive officers, persons
      who beneficially own more than 5% of our outstanding common stock, and the
      family members and other affiliates of such persons. All such transactions
      are
      consummated on substantially the same terms, including interest rates and
      collateral, as those prevailing for comparable transactions with other
      customers. The following table sets forth information with respect to
      investments in our investor notes by related persons (as defined in Item 404
      of
      the SEC’s Regulation S-B) since January 1, 2006 in which the amount involved
      exceeded the lesser of $120,000 or 1.00% of our average total assets at year-end
      for the last three completed fiscal years. We did not engage in any other
      transactions with a related person requiring disclosure pursuant to Item 404
      of
      Regulation S-B.




47




**INVESTOR
      NOTE ACCOUNTS**





**Investor**
            
            **Relationship**
            
            **Beginning**
              **Balance**
            
            **Balance as**
              **of 12/31/07**
            
            **Highest Balance**
              **During Period**
              **1/1/2006 –**
              **12/31/2007**
            
            **Interest**
              **Rate**Mervyn
                Feldman
            
            
            Director
            
            $
            17,239
            
            $
            15,288
            
            $
            42,949
            
            
            6.00
            %Mervyn
                Feldman
            
            
            Director
            
            $
            486,725
            
            $
            471,172
            
            $
            549,711
            
            
            6.25
            %Mervyn
                Feldman
            
            
            Director
            
            $
            14,715
            
            $
            2,632
            
            $
            43,596
            
            
            6.00
            %Mervyn
                Feldman
            
            
            Director
            
            $
            21,393
            
            $
            433
            
            $
            40,389
            
            
            6.00
            %Mervyn
                Feldman
            
            
            Director
            
            $
            52,769
            
            $
            36,636
            
            $
            73,415
            
            
            6.25
            %James
                Parker
            
            
            Officer
            
            $
            69,954
            
            $
            117
            
            $
            102,731
            
            
            6.00
            %Doug
                Kelly
            
            
            Stockholder
            
            $
            1,287
            
            $
            4,734
            
            $
            158,331
            
            
            6.25
            %Louise
                Sehman
            
            
            Officer
            
            $
            14,503
            
            $
            9,613
            
            $
            17,519
            
            
            6.25
            %Jin
                S. Kim
            
            
            Stockholder
            
            $
            220,155
            
            $
            (10,725
            )
            $
            262,775
            
            
            7.75
            %Jin
                S. Kim
            
            
            Stockholder
            
            $
            8,192
            
            $
            10,022
            
            $
            10,022
            
            
            7.85
            %Richard
                Allen
            
            
            Stockholder
            
            $
            2,118
            
            $
            2,232
            
            $
            2,232
            
            
            9.06
            %Richard
                Allen
            
            
            Stockholder
            
            $
            621,645
            
            $
            1,466
            
            $
            629,301
            
            
            6.25
            %Solomon
                Kaspi
            
            
            Stockholder
            
            $
            35,885
            
            $
            47,007
            
            $
            47,007
            
            
            9.00
            %Solomon
                Kaspi
            
            
            Stockholder
            
            $
            40,817
            
            $
            66,657
            
            $
            66,657
            
            
            9.00
            %Solomon
                Kaspi
            
            
            Stockholder
            
            $
            6,723
            
            $
            9,779
            
            $
            1,997,804
            
            
            6.25
            %Solomon
                Kaspi
            
            
            Stockholder
            
            $
            3,182
            
            $
            4,045
            
            $
            4,045
            
            
            8.00
            %Solomon
                Kaspi / AIG
            
            
            Stockholder
            
            $
            21,917
            
            $
            4,533,792
            
            $
            4,533,792
            
            
            6.25
            %Jack
                Breskow
            
            
            Director
            
            $
            2,694
            
            $
            522
            
            $
            13,133
            
            
            6.00
            %Eufrosyne
                Breskow
            
            
            Stockholder
            
            $
            5,180
            
            $
            683
            
            $
            27,755
            
            
            6.00
            %Jack
                Breskow
            
            
            Director
            
            $
            3,117
            
            $
            223
            
            $
            12,467
            
            
            6.00
            %Robert
                Harris
            
            
            CEO
            
            $
            4,543
            
            $
            2,751
            
            $
            219,471
            
            
            6.25
            %





**Director
      Independence**





The
      Board
      of Directors has determined that each of our current directors, except for
      Robert L. Harris who serves as our Chief Executive Officer and Chief Financial
      Officer, is an “independent director” as that term is defined by Section 803A(2)
      of the American Stock Exchange Company Guide. Additionally, both Messrs. Connor
      and Shapiro satisfy the audit committee independence requirements of Section
      803B(2) of the American Stock Exchange Company Guide.





**ITEM
      13.**  **EXHIBITS**




The
      exhibits filed or furnished with this report are listed in the Exhibit Index
      which immediately follows the signatures to this report, and this Exhibit Index
      is incorporated herein by reference.





**ITEM
      14.**  **PRINCIPAL
      ACCOUNTANT FEES AND SERVICES**




As
      our
      independent registered public accounting firm for 2006 and 2007, Stegman &
Company provided various audit and other services for which we were billed
      for
      fees as further described below. Except as described below, the Audit Committee
      specifically pre-approves all audit services and other services provided by
      Stegman & Company. In the case of tax services and other permissible
      non-audit services, the Audit Committee has delegated authority to its Chairman
      to approve services. Any approval of additional services by the Chairman is
      communicated to the full Audit Committee at its next regularly scheduled
      meeting. The Audit Committee also may authorize management to obtain tax
      services from Stegman & Company from time to time during the year up to a
      specified aggregate amount of fees. Any tax services obtained by management
      is
      communicated to the Audit Committee at its next regularly scheduled
      meeting.




The
      following table shows the fees paid or accrued by us for the audit and other
      services provided by Stegman & Company during fiscal years 2007 and 2006:





**2007**
            
            **2006**Audit
                Fees
            
            $
            47,094
            
            $
            52,844Audit-Related
                Fees
            
            
            -
            
            
            -Tax
                Fees
            
            
            7,250
            
            
            6,500All
                Other Fees
            
            
            -
            
            
            -**Total**
            
            **$**
            **54,344**
            
            **$**
            **59,344**





Audit
      Fees paid or incurred in fiscal years 2007 and 2006 include charges for the
      examination of our consolidated financial statements and quarterly reviews
      of
      financial statements. Tax Fees paid in fiscal years 2007 and 2006 include
      charges primarily related to tax return preparation. The Audit Committee has
      reviewed summaries of the services provided and the related fees and has
      determined that the provision of non-audit services is compatible with
      maintaining the independence of Stegman & Company.





All
      of
      the 2007 and 2006 services described above were pre-approved by the Audit
      Committee.




48




**SIGNATURES**




In
      accordance with Section 13 or 15(d) of the Exchange Act, the registrant has
      caused this report to be signed on its behalf by the undersigned, thereunto
      duly
      authorized.




Dated:
                April 14, 2008
            **KH
                FUNDING COMPANY**By:
            /s/
                Robert L. HarrisRobert
                L. Harris,President
                and Chief Executive Officer, Chief Financial
                Officer




In
      accordance with the Exchange Act, this report has been signed below by the
      following persons on behalf of the registrant and in the capacities on April
      14,
      2008.





**Name**
            
            **Title**/s/
                Robert L. Harris
            
            President,
                Chief Executive Officer, Chief Financial Officer and
                DirectorRobert
                L. Harris/s/
                Jack H. Breskow
            
            DirectorJack
                H. Breskow/s/
                Jeremiah A. Connor
            
            DirectorJeremiah
                A. Connor/s/
                Alvin Shapiro
            
            DirectorAlvin
                Shapiro




49


**EXHIBIT
      INDEX**





**Exhibit**
            
            **Description**3.1(i)
            
            Articles
                of Incorporation of KH Funding Company (Incorporated by reference
                to
                Exhibit 3.1 of the Registrant’s Registration Statement on Form SB-2 filed
                on June 26, 2003, File No. 333-106501)3.1(ii)
            
            Articles
                of Amendment of KH Funding Company (Incorporated by reference to
                Exhibit
                3.2 of the Registrant’s Registration Statement on Form SB-2 filed on June
                26, 2003, File No. 333-106501)3.2
            
            Bylaws
                of KH Funding Company (Incorporated by reference to Exhibit 3.3 of
                the
                Registrant’s Registration Statement on Form SB-2 filed on June 26, 2003,
                File No. 333-106501)4.1
            
            Indenture
                by and between KH Funding Company, as Issuer, and Wells Fargo Bank
                Minnesota, N.A., as Trustee, dated August 27, 2003 (Incorporated
                by
                reference to Exhibit 4 of the Registrant’s Registration Statement on Form
                SB-2 filed on June 26, 2003, File No. 333-106501)4.2
            
            Indenture
                by and between KH Funding Company, as Issuer, and Wells Fargo Bank
                Minnesota, N.A., as Trustee, dated August 2, 2004 (Incorporated by
                reference to Exhibit 4 of the Registrant’s Post-Effective Amendment No. 1
                to the Registration Statement on Form SB-2 filed on July 11, 2005,
                File
                No. 333-117038)4.3
            
            First
                Supplemental Indenture by and between KH Funding Company, as Issuer,
                and
                Wells Fargo Bank, N.A., as Trustee, dated July 1, 2005 (Incorporated
                by
                reference to Exhibit 4.3 of the Registrant’s Pre-Effective Amendment No. 2
                to the Registration Statement on Form SB-2 filed on July 1, 2005,
                File No.
                333-124155)4.4
            
            Security
                Agreement by and between KH Funding Company, as Issuer, and Wells
                Fargo
                Bank, N.A., as Trustee, dated May 18, 2005 (Incorporated by reference
                to
                Exhibit 4.4 of the Registrant’s Pre-Effective Amendment No. 1 to the
                Registration Statement on Form SB-2 filed on June 1, 2005, File No.
                333-124155)4.5
            
            Deposit
                Account Control Agreement by and among KH Funding Company, as Issuer,
                Wells Fargo Bank, N.A., as Trustee, and Access National Bank, dated
                June
                15, 2005 (Incorporated by reference to Exhibit 4.5 of the Registrant’s
                Pre-Effective Amendment No. 2 to the Registration Statement on Form
                SB-2
                filed on July 1, 2005, File No. 333-124155)4.6
            
            Amended
                and Restated Second Supplemental Indenture by and between KH Funding
                Company, as Issuer, and Wells Fargo Bank, N.A., as Trustee, dated
                January
                16, 2008(Incorporated
                by reference to Exhibit 4.6 of the Registrant’s Post-Effective Amendment
                No. 2 to the Registration Statement on Form SB-2 filed on January
                23,
                2008, File No. 333-135330)4.7
            
            Account
                Control Agreement by and among KH Funding Company, as Issuer, Wells
                Fargo
                Bank, N.A., as Trustee, and the brokerage company a party thereto,
                dated
                September 17, 2007 (Incorporated by reference to Exhibit 4.7 of the
                Registrant’s Post-Effective Amendment No. 2 to the Registration Statement
                on Form SB-2 filed on January 23, 2008, File No.
                333-135330)4.8
            
            Deposit
                Account Control Agreement by and among KH Funding Company, as Issuer,
                Wells Fargo Bank, N.A., as Trustee, and Bank of America, N.A., dated
                October 17, 2006 (Incorporated by reference to Exhibit 4.8 of the
                Registrant’s Post-Effective Amendment No. 1 to the Registration Statement
                on Form SB-2 filed on August 10, 2005, File No.
                333-135330)10.1
            
            1998
                Stock and Incentive Plan (Incorporated by reference to Exhibit 10.1
                of the
                Registrant’s Registration Statement on Form SB-2 filed on June 26, 2003,
                File No. 333-106501)10.2
            
            Form
                of Participation Agreement (Incorporated by reference to Exhibit
                10.2 of
                the Registrant’s Registration Statement on Form SB-2 filed on June 30,
                2005, File No. 333-117038)10.3
            
            2005
                Equity Incentive Plan (Incorporated by reference to Exhibit 10.3
                of the
                Registrant’s Registration Statement on Form SB-2 filed on June 10, 2005,
                file No 333-124155)10.4
            
            Selling
                Agreement by and between KH Funding Company and Spencer Edwards,
                Inc.
                (Incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-KSB
                for the year ended December 31, 2004)10.5
            
            Selling
                Agreement by and between KH Funding Company and Capital Financial
                Services, Inc. (Incorporated by reference to Exhibit 10.3 of the
                Registrant’s Registration Statement on Form SB-2 filed on June 30, 2005,
                file No. 333-117038)10.6
            
            Selling
                Agreement by and between KH Funding Company and CapWest Securities,
                Inc.
                (Incorporated by reference to Exhibit 10.6 of the Registrant’s
                Pre-Effective Amendment No. 1 to the Registration Statement on Form
                SB-2
                filed on August 10, 2005, File No. 333-135330)10.7
            
            Promissory
                note dated July 12, 2006 issued by Jin Suk Kim to KH Funding Company
                and
                related Pledge Agreement and Guaranty (Incorporated by reference
                to
                Exhibit 10.1 of the Registrant’s Form 10-QSB for the quarter ended June
                30, 2007)10.8
            
            Promissory
                note dated August 10, 2006 issued by Jin Suk Kim to KH Funding Company
                and
                related Indemnity Deed of Trust and Security Agreement (Incorporated
                by
                reference to Exhibit 10.2 of the Registrant’s Form 10-QSB for the quarter
                ended June 30, 2007)10.9
            
            Promissory
                note dated September 12, 2006 issued by Jin Suk Kim to KH Funding
                Company
                (Incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-QSB
                for the quarter ended June 30, 2007)31.1
            
            Certifications
                by the Chief Executive Officer and Chief Financial Officer pursuant
                to
                Section 302 of the Sarbanes-Oxley Act of 2002 (filed
                herewith)32.1
            
            Certification
                by the Chief Executive Officer and Chief Financial Officer Pursuant
                to 18
                U.S.C. Section 1350 Adopted Pursuant to Section 906 of the Sarbanes-Oxley
                Act of 2002 (furnished herewith)





50