**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, 2006**





**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**(Title
                of class)









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 **$6,219,927** .




State
      the
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates computed by reference to the price at which the common equity
      was
      sold, or the average bid and asked price of such common equity, as of a
      specified date within the past 60 days. There is no market for the registrant's
      common equity.














**PART
      I**




**INTRODUCTORY
      STATEMENT**




The
      information contained in this report pertains to the registrant, KH Funding
      Company. References to the "Company," "KH Funding" or "we," "our" and "us"
      refer
      to KH Funding Company.




**FORWARD-LOOKING
      STATEMENTS**




Some
      of
      the statements contained in this annual report discuss future expectations,
      and
      other "forward-looking" information. Those statements are subject to known
      and
      unknown risks, uncertainties and other factors that could cause the actual
      results to differ materially from those contemplated by the statements. The
      "forward-looking" information is based on various factors and was derived using
      numerous assumptions. In some cases, you can identify these so-called
      "forward-looking statements" by words like "may," "will," "should," "expects,"
      "plans," "anticipates," "believes," "estimates," "predicts," "potential," or
      "continue" or the negative of those words and other comparable words. You should
      be aware that those statements only reflect our predictions. Actual events
      or
      results may differ substantially. Important factors that could cause our actual
      results to be materially different from the forward-looking statements are
      disclosed under the heading "Item 1. Description of Business—Risk
      Factors."




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




**General**




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




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




**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. We also administer our program of issuing and selling
      fixed and variable rate debt securities of varying maturities. Our mortgage
      banking and investor Note operations are similar to those of commercial banks,
      which administer their assets for the benefit of its stockholders and
      depositors.




Our
      assets of $63.33 million as of December 31, 2006 consist primarily of cash,
      mortgages, 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 Notes; and maintain and track the receipts,
      disbursements and balances on escrow accounts established by the
      borrowers.




The
      following table sets forth certain information relating to KH Funding Company
      for the five years ended December 31, 2006. 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
      notes receivable or notes payable, respectively, for the years shown. The
      interest categories are at contractual 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**2002
            
            11.00%
            
            6.40%
            
            4.60%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%




**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
      commercially in use by over 300 other subscribers. Our investment account
      software was made to our specifications to allow us to service our Note holders
      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
      www.khfunding.com. The web site allows investors to view their account
      information at anytime, such as account balances, maturity dates and recent
      transactions. Access to the web site 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. The additional funds necessary to
      carry through with this strategy will be obtained through the sale of investor
      Notes. In addition, we may seek to raise funds through private sale of our
      capital stock.




We
      intend
      to continue managing our assets and our collection procedures for any problem
      assets. We expect to realize increased operating efficiencies and cost controls
      as we invest the proceeds from future Note offerings. We do not expect that
      we
      will need to add significant additional personnel or expanded facilities for
      the
      administration and investment of the additional proceeds from our public
      offerings.




**Market
      Area and Credit Risk Concentration**




Our
      lending activities are concentrated primarily in the Washington, D.C. and
      Baltimore, MD metropolitan areas. We also purchase residential mortgage loans
      from banks and other lenders in other states. As of December 31, 2006, our
      average loan size was approximately $237,000. Our larger loans, above $250,000,
      are made with a strong emphasis on collateral-based underwriting as opposed
      to
      relying primarily on credit scoring.




-3-





**Competition**




KH
      Funding Company faces 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 we compete directly with smaller, local 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.




We
      are
      finding that in originating and acquiring loans, there has been increased
      competition from large institutions. This trend is not material at this point
      as
      there is a sufficient amount of quality product available from smaller lenders
      and banks that can and do operate at our level. 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.




We
      believe that we will continue to be able to attract investors to our investment
      products. Our one, three and five-year term investments are priced at a rate
      that is normally more than 200 basis points (2%) above insured investments
      for a
      similar term at commercial banks. Our daily and 30-day liquidity products are
      competitively priced with other uninsured investments that have similar features
      such as checking account and withdrawal features. We provide holders of one-day
      demand Notes with checking accounts to access their funds through a third-party
      bank. The checking account privileges are exclusively for funds invested in
      investment 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 trust real estate-backed loans
      that we have originated or acquired from other lenders. We also have 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 or other investments.




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
      from
      which we may acquire 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.




***First
      Trust Lending***




*Direct
      Origination* .
      We
      primarily originate first trust loans for investment (rented) residential real
      estate, and small commercial properties. The loans we originate have a
      loan-to-value (LTV) of 80% or less. Credit scores of the borrowers and
      guarantors generally range in the mid 600's. 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.




-4-


*Acquired
      Loans* .
      The
      first trust loans we acquire nationwide are generally 70% 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%. At
      present, our loan portfolio has none of the aggressive Adjustable-Rate-Mortgage
      loan products that are causing much of the concern regarding sub-prime borrowers
      in the mortgage lending industry.




***Second
      Trust Lending***




*Direct
      Origination* .
      The
      majority of our stand-alone, second trust loans, in which we do not have a
      first
      trust on the property, are on owner-occupied properties in which the borrowers
      are consolidating debts. The average LTV 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 2004.




*Acquired
      Loans* .
      We only
      acquire second trust loans if they have a total LTV 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 trusts
      in 2000, as we would prefer to also own the first trust when a loan has a
      combined LTV of more than 90%. However, if borrowers have a credit score in
      the
      low to mid 600's, or higher, we purchase such stand-alone second trusts. Our
      second trust portion of our loan portfolio represents only 2% of our total
      loan
      portfolio. At December 31, 2006, we had $396,855 in direct origination second
      trust loans and $756,632 in purchased second trust 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 businesses 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 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 adequately 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 a reasonable 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 its accounts
      receivable.




***Other
      Assets Lending***




Some
      of
      the loans in our portfolio are not secured by real estate or business assets.
      Automobiles and 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.




***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.




-5-




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




**Year
                Ended December 31,****Loans
                By Collateral Type**
            
            **2006**
            
            **2005**Residential
                Real Estate First Trust
            
            $
            15,403,919
            
            $
            6,801,401Business
                Assets and Commercial Real Estate First Trust
            
            
            2,948,930
            
            
            5,159,408Residential
                Investment Property First Trust
            
            
            33,023,531
            
            
            24,557,183Residential
                Real Estate Second Trust
            
            
            1,153,487
            
            
            2,103,760Other
                Assets (Auto, Stock)
            
            
            1,978,712
            
            
            2,035,215Other
                Loans (Over Equity, Medical and Unsecured)
            
            
            407,7751
            
            
            441,843Total
                loans receivable
            
            
            54,916,330
            
            
            41,098,810Unearned
                fees and other
            
            
            239,844
            
            
            (50,078
            )Less
                allowance for loan losses
            
            
            (452,154
            )
            
            (369,791
            )Total
                loans receivable, net
            
            $
            54,704,020
            
            $
            40,678,941




*Loan
      Approval Procedures and Authority* .
      The
      Chief Executive Officer may approve any loan up to and including $500,000.
      The
      Chief Executive Officer and another member of our Board of Directors together
      must approve all loans over $500,000.




The
      Company has no internal appraisers and, as such, it relies 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
      trust mortgage loans. In addition, we may require borrowers to make payments
      to
      a mortgage escrow account for the payment of property taxes.




**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 $651,895 and $836,390 at December 31, 2006 and 2005,
      respectively.




As
      of
      December 31, 2006 and 2005, the Company had loans of $1,748,342 and $1,625,356,
      respectively, which were more than ninety days past due and for which the
      Company continues to accrue interest. The Company has adequate collateral for
      these loans and management believes that both the principal and the related
      accrued interest are collectible.





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. As
      of December 31, 2006 and 2005, the Company had held for sale real estate owned
      of $325,223 and $180,302, respectively, which are considered non-performing
      assets. As of December 31, 2006 and 2005, the Company had real estate owned
      held
      as rental property of $814,441 and $622,513, respectively.




**Allowance
      for Loan Losses**




We
      maintain an allowance for loan losses. The allowance is increased by
      corresponding charges to the 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 collection is questionable).
      If KH Funding has specific knowledge or some other reason to consider that
      a
      loan may be impaired, management reviews the loan to determine if impairment
      has
      occurred. 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 asset 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**2002
            
            $
            14,823,498
            
            $
            139,069
            
            
            0.94
            %2003
            
            $
            15,900,842
            
            $
            111,278
            
            
            0.75
            %2004
            
            $
            17,676,284
            
            $
            244,389
            
            
            1.38
            %2005
            
            $
            32,473,227
            
            $
            114,568
            
            
            0.35
            %2006
            
            $
            49,784,567
            
            $
            230,495
            
            
            0.46
            %




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




**2006**
            
            
            **2005**Loans
                on non-accrual status
            
            $
            651,895
            
            $
            836,390Real
                estate held for sale
            
            
            325,223
            
            
            180,302Total
                nonperforming assets
            
            $
            977,118
            
            $
            1,016,692Loans
                90 days past due and still accruing interest
            
            $
            1,748,342
            
            $
            1,625,356




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




**Off-Balance
      Sheet Arrangements**




We
      enter
      into off-balance sheet arrangements in the normal course of our business. These
      arrangements consist primarily of our loans which are lines-of-credit or
      draw-type loans. At December 31, 2006 we had $16.3 million in loans of this
      type. The unused or unfunded amount on these types of loans totaled
      $ 3.42 .




In
      addition to our credit commitment as outlined above we have certain contractual
      obligations. See our discussion entitled “Liquidity and Capital Resources” for
      more information.




**Governmental
      Regulations**




In
      the
      future, our operations may become 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;




·
            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;
                or




·
            subject
                us to potential claims, defenses and other
                obligations.




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.




-7-




In
      addition, 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.




**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 borrowers 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, our founder and Chief Executive
                Officer;




·
            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.




**Personnel**




At
      December 31, 2006, we had six full-time and five part-time employees. We
      consider our relationship with each of our employees to be good.




**Risk
      Factors**




Our
      business, results of operations and financial condition are subject to a number
      of risks, including the risks set forth below. You should carefully consider
      these risks. 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.




-8-







*Our
      assessment of the quality of loans we acquire may be inaccurate which could
      adversely affect our profitability.*




Before
      we
      purchase or originate loans, we perform an evaluation of the loans in order
      to
      determine whether they are eligible for our portfolio. There is no guarantee
      that the initial analysis of these loans will reflect actual future results
      which, if unfavorable, could adversely affect our profitability. See "Item
      1.
      Description of Business—Lending Activities."





*We
      originate and purchase sub-prime loans that have higher delinquency and default
      rates than prime mortgage loans, which could result in losses on
      loans.*




In
      the
      last five years we have increased our purchasing of closed loans from brokers,
      banks and other lenders. These loans are hard-collateral and sub-prime closed
      loans, and we have long-standing relationships with the brokers, banks and
      other
      lenders from whom we purchase loans. We intend to continue to expand this
      component of our operations. Hard-collateral and sub-prime mortgage loans
      generally have higher delinquency and default rates than prime mortgage loans.
      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.




There
      is
      no generally accepted definition of a “sub-prime” mortgage loan. However, many
      industry participants classify loans to borrowers with credit scores of 620
      or
      less as sub-prime. In addition, industry participants often refer to loans
      with
      loan to value ratios of 95% and higher as sub-prime.





We
      attempt to manage risks associated with the sub-prime portion of our loan
      portfolio by using risk-based mortgage loan pricing and appropriate underwriting
      policies and loan collection methods. Generally, the loans that we originate
      or
      purchase where the borrowers have a credit score under 620, have loan to value
      ratios that are less than 70%, as opposed to ratios of 95% or higher allowed
      by
      many sub-prime lenders. In addition, we do not offer abusive products such
      as
      so-called “teaser” rate adjustable loans, low or no document or “stated income”
loans that have been heavily criticized by regulators, commentators and
      Congress. However, if our 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
      significantly harmed.




*If
      all of the remedies for recovering a defaulted loan that we own are inadequate,
      it could have a materially adverse effect on our financial
      results.*




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;




·
            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
      cannot assure you that we will not 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
      the
      balance budgeted to our loan losses. We do not maintain insurance covering
      such
      losses. In addition, the amount of provisions for loan losses may be 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 "Item 1.
      Description of Business—Allowance for Loan Losses."




-9-




*Our
      results of operations depend significantly on economic conditions in the
      Baltimore-Washington metropolitan area.*




Our
      operations depend primarily upon 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 the 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.




*Our
      lack of diversified operations and investments increases our exposure to risk
      of
      loss.*




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 in
      originating loans 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 real estate properties upon which we have foreclosed.
      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 loans become uncollectible. This increases the risk that uncollectible loans
      could materially affect our financial results.




*We
      operate limited levels of capital levels or stockholders' equity, so in the
      event of the liquidation or dissolution of the Company holders of our Notes
      could lose all or a part of their investment.*




A
      company's capital represents the investment of its stockholders and is paid
      last, after all debt holders have been paid, in the event of a liquidation
      or
      dissolution of the company. Therefore, a greater amount of capital provides
      a
      greater amount of protection to debt holders in the event of a liquidation
      or
      dissolution. Our capital level provides only a modest amount of protection
      to
      the holders of our Notes. Therefore, in the event of an insolvency or
      liquidation, the holders of our Notes could lose all or part of their
      investment.




*Rapid
      changes, either upward or downward, in interest rates may adversely affect
      our
      financial condition or results of operations.*




Any
      future rise in interest rates may:




·
            reduce
                customer demand for our loan and investor Note
                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 outstanding debt securities;
                and




·
            limit
                our access to borrowings in the capital
                markets.




We
      are
      subject to risks associated with decreases in interest rates especially to
      the
      extent that we have issued fixed rate debt securities with scheduled maturities
      of over one year. At December 31, 2006, we had $14,940,718 debt securities
      with
      scheduled maturities greater than one year. If market interest rates decrease
      in
      the future, the rates paid on our long term debt securities could exceed the
      current market rate paid for similar instruments which could result in a
      reduction in our profitability and which could impair our ability to redeem
      the
      debt securities.




-10-




*If
      we
      are not able to sustain the levels of loan originations that we experienced
      in
      the past, our future operating results may be adversely affected and our ability
      to redeem our Notes may be impaired.*




It
      is
      necessary for us to continue adding loans to our investment portfolio because
      we
      need to re-invest proceeds of loan payoffs as they are received. We will also
      need to invest in more mortgages as we grow in size. Our ability to sustain
      the
      level of loan originations needed depends upon a variety of factors outside
      our
      control, including:




·
            interest
                rates;




·
            economic
                conditions in our primary market
                area;




·
            changes
                in real estate values;




·
            competition;
                and




·
            regulatory
                restrictions.




In
      a
      rising interest rate environment, we would expect our ability to originate
      loans
      at interest rates that will maintain our current margins will be easier compared
      to a falling or stable interest rate environment. If we are unable to sustain
      our levels of growth, our profits may be reduced and our ability to repay the
      debt securities upon maturity may be impaired.





We
      recently exercised our right to make a mandatory call of Notes from certain
      holders of Notes that are residents of states in which our offering was not
      registered or otherwise may not have been qualified under those states’ blue sky
      laws. Accordingly, we redeemed a total of $1.47 million in principal and
      interest amounts of Notes during late December 2006 and early January 2007.
      We
      have also offered to redeem Notes from holders in certain other states who
      hold
      an aggregate of $3.58 million in principal and interest amounts of Notes. Our
      offer to redeem Notes may only be declined by persons who are accredited
      investors that purchased a significant amount of investor Notes. The Company
      anticipates that it will redeem approximately $450,000 in principal amount
      of
      investor Notes from holders who do not qualify to decline the redemption offer
      in April 2007. We also anticipate that a small number of accredited investors
      who hold approximately $3.1 million of investor Notes, most of whom are
      affiliates of the Company or existing Note holders, will not elect rescission
      and will retain their investor Notes. We intend to use existing cash resources
      and principal and interest payments on our loan portfolio to satisfy any
      redemption requests and do not believe that we will need to liquidate any of
      our
      mortgage loan portfolio.




*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
      best
      estimate of probable losses that have been incurred within the existing
      portfolio of loans. The level of the allowance reflects management's continuing
      evaluation of concentrations; specific credit risks; loan loss experience;
      current loan portfolio quality; present economic, political and regulatory
      conditions; and unidentified losses inherent in the current loan portfolio.
      The
      determination of the appropriate level of the allowance for loan losses
      inherently involves a high degree of subjectivity and requires the Company
      to
      make significant estimates of current credit risks and future trends all of
      which may undergo material changes. Changes in economic conditions affecting
      borrowers, new information regarding existing loans, identification of
      additional problem loans and other factors, both within and outside of the
      Company's control, may require an increase in the allowance for possible loan
      losses. In addition, charge-offs in future periods may exceed the allowance
      for
      loan losses. Increases in the allowance for loan losses will result in an
      increase in expenses, and may have a material adverse effect on the Company's
      financial condition and results of operations.




*We
      are dependent on our senior management team and, if we are not able to retain
      them, it could have a materially adverse effect on us.*




We
      are
      dependent upon the continued services and experience of our senior management
      team, including Robert L. Harris, our Chief Executive Officer and President,
      James E. Parker, our Chief Financial Officer, Louise Sehman, our Secretary
      and
      Treasurer, Martin Angeli, our Senior Vice President and Ronald L. Nicholson,
      a
      Vice President. We depend on the services of Messrs. Harris, Angeli and Parker
      and Ms. Sehman and other 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 agreements with any of our 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 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.




-11-




*We
      are subject to environmental liability risk associated with lending
      activities.*




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 that we
      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.




*We
      have notes payable and notes receivable with certain of our officers, directors
      and principal stockholders. This might cause such persons to have a conflict
      of
      interest.*




As
      of
      December 31, 2006, some of our officers, directors and stockholders held notes
      payable from us totaling $7,421,423. Although the equity ownership of these
      individuals tends to encourage them to act in the best interests of all
      stockholders, circumstances could arise in which such persons, particularly
      those that are members of our Board of Directors, will be in a position of
      allocating available cash and our resources in a manner that may not be in
      the
      best interests of other stockholders. In addition, as of December 31, 2006,
      we
      had loans held outstanding to some of our officers, directors and stockholders
      of $9,284,428. Although we believe that each of these loans were made on terms
      as favorable to us as could have been obtained from an unrelated party, the
      loans could create, or appear to create, potential conflicts of interest which
      may not necessarily be resolved in our favor. Our policies for underwriting
      mortgage loans and purchasing loans secured by real property are discussed
      under
      "Item 1. Description of Business—Lending Activities." This could have a material
      adverse effect on our business, operating results and financial condition.
      See
      "Item 14. Certain Relationships and Related Transactions."




*We
      do
      not have a compensation committee.*




We
      do not
      have a compensation committee and have no current plans to form such a
      committee. In the meantime, our Board of Directors governs decisions regarding
      compensation. Our Board of Directors is not entirely comprised of independent
      members. See “Item 9. Directors, Executive Officers, Promoters, and Control
      Persons.”




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




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.




-12-




We
      currently own residential real estate in the following areas:




·
            one
                property held for sale in Louisville,
                Mississippi;




·
            two
                properties held for sale in Schenectady, New
                York;




·
            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 in Schenectady, New
                York;




·
            one
                rental property in Montgomery,
                Alabama;




·
            one
                rental property in Waco, Texas;




·
            two
                rental properties in Leander, Texas;
                and




·
            two
                rental properties in Greenwood, South
                Carolina




·
            one
                rental property in Silver Spring,
                Maryland.




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




We
      are
      involved periodically in various claims and lawsuits that arise in connection
      with our financial services business. We believe that these routine legal
      proceedings, in the aggregate, are not material to our financial condition
      and
      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 2006.


-13-




**PART
      II**




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




**Market,
      Holders and Dividends**




Our
      common stock is not listed on a public trading market. As of March 15, 2007
      we
      had 53 stockholders of record holding 2,726,951 shares. For the last two fiscal
      years we have paid an annual dividend on our common stock of $0.08 per share
      and
      anticipate paying additional dividends on our common stock in the foreseeable
      future.




**Equity
      Compensation Plan Information**




The
      following table sets forth information as of March 15, 2007 with respect to
      the
      compensation plans under which equity securities of the Company are authorized
      for issuance.





**Equity
                Compensation Plan Information****Plan
                category**
            
            **(a)
                Number of shares to be issued upon exercise of outstanding
                options**
            
            **(b)
                Weighted-average exercise price of outstanding
                options**
            
            **(c)
                Number of shares remaining available for future issuance under equity
                compensation plans (excluding shares reflected in column
                (a))**Equity
                compensation plans approved by security holders(1)
            
            
            150,000
            
            $
            3.10
            
            
            850,000Equity
                compensation plans not approved by security holders(2)
            
            
            321,250
            
            $
            2.08
            
            
            n/aTotal
            
            
            471,250
            
            $
            2.40
            
            
            850,000


(1)
              The
                  2005 Incentive Plan was approved by stockholders in
                  2005.




(2)
            From
                time to time, we have issued options or warrants 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. These issuances have not been made
                pursuant
                to a formal policy or plan, but instead are issued with such terms
                and
                conditions as may be determined by our Board of Directors from time
                to
                time.




**Recent
      Sales of Unregistered Securities**





During
      the year ended December 31, 2006, the Company completed a private placement
      of
      121,495 shares of the Company's common stock at a purchase price of $3.00 per
      share. Net proceeds to the Company were $364,484. The private placement was
      consummated without registration under the Securities Act in reliance upon
      the
      exemption from registration pursuant to Section 4(2) of the Securities Act
      and
      Rule 506 of Regulation D promulgated thereunder. All of the purchasers were
      existing stockholders of the Company and are believed by the Company to be
      "accredited investors" within the meaning of the Securities Act.





In
      addition, during the year ended December 31, 2006, the Company issued a total
      of
      12,900 shares of common stock to members of the Board of Directors and certain
      employees of the Company for services rendered. Also, during the year ended
      December 31, 2006, options were exercised which resulted in 40,000 shares
      purchased at $2.00 per share with net proceeds to the Company of $80,000. The
      shares were issued without registration under the Securities Act in reliance
      upon the exemption from registration pursuant to Section 4(2) of the Securities
      Act and Rule 506 of Regulation D promulgated thereunder.




**Repurchase
      of Securities**




The
      Company repurchased 3,000 shares of Common Stock for $7,200 from one shareholder
      during 2006.




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




This
      discussion may contain statements that could be deemed forward-looking
      statements within the meaning of Section 21E of the Securities Exchange Act
      of
      1934 and the Private Securities Litigation Reform Act, which statements are
      inherently subject to risks and uncertainties. Forward-looking statements are
      statements that include projections, predictions, expectations or beliefs and
      future events or results or otherwise are not statements of historical fact.
      Such statements are often characterized by the use of qualifying words (and
      their derivatives) such as "expect," "believe," "estimate," "plan," "project,"
      "anticipate," or other statements concerning opinions or judgment of
      KH
      Funding and its management about future events. Factors that could influence
      the
      accuracy of such forward-looking statements include, but are not limited to,
      the
      financial success or changing strategies of KH Funding's customers, actions
      of
      government regulators, the level of market interest rates, and general economic
      conditions. See "Forward-Looking Statements."




-14-




**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.




KH
      Funding currently has over 1,500 investors who have purchased its investment
      Notes dating back to 1990. The note purchasers have been attracted primarily
      through word-of-mouth referrals. The proceeds from the sale of Notes are used
      to
      make redemptions to existing note holders and for investment in real estate
      mortgage loans, business loans, investment grade debt securities and real
      property. We emphasize the direct origination of small commercial real estate
      mortgage loans and investment property residential mortgage loans. We purchase
      first and second trust residential loans nationwide from other lenders and
      banks.




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




Since
      the
      fourth quarter of 2004, the Company has been expanding the distribution channels
      for sales of its 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 Broker-Dealers with a network of over 250
      registered representatives in the Midwest and West. These alliances gave us
      the
      ability to sell our investor Notes through a network of financial consultants
      in
      defined geographic locations. To date, our distribution plan has been very
      successful, establishing close to 700 new investment accounts providing over
      $25,000,000 in funds to KH Funding. However, since the public offering for
      our
      Notes expired in the second quarter of 2006, our fund raising activity has
      been
      greatly impaired. We expect to have a new offering in place by the end of May
      2007 and to resume sale of our notes. We anticipate successful, controlled
      growth going forward.





Recently,
      the sub-prime mortgage banking environment has been experiencing considerable
      strain from rising delinquencies and liquidity pressures and several sub-prime
      mortgage lenders have failed. The increased scrutiny of the sub-prime lending
      market is one of the factors that have impacted general market conditions,
      as
      well as several significant sub-prime mortgage originators. Although we engage
      as part of our business in sub-prime lending, we believe that our exposure
      to
      problems in the industry are limited as a result of several factors. First,
      we
      believe that we are underwriting our sub-prime mortgage loans to a much higher
      standard than the failing and delinquent loans from the more aggressive lenders
      in the mortgage industry. Second, we do not offer any of the loan products
      that
      are receiving the harshest criticism from regulators, commentators and Congress.
      Specifically, as a general matter the sub-prime loans that we originate or
      purchase have loan to value ratios that are less than 70%, as opposed to ratios
      of 95% or higher allowed by many sub-prime lenders. In addition, we do not
      offer
      so-called “teaser” rate adjustable loans, low or no document or “stated income”
loans. Third, our size does not require us to generate or purchase high volumes
      of sub-prime mortgage loans so we can look much more closely at the individual
      borrowers, 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. Of course, if there is a major downturn in real estate values,
      our procedures and practices may not be adequate to prevent or materially
      diminish an adverse affect on our financial condition or results of operations.
      See Item 1. “Business-Risk Factors-We originate and purchase sub-prime loans
      that have higher delinquency and default rates than prime mortgage loans, which
      could result in losses on loans.”




-15-




**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,****2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002****Statement
                of Operations Data:**Total
                Interest Income
            
            $
            6,144,252
            
            $
            3,534,054
            
            $
            2,274,933
            
            $
            1,968,514
            
            $
            1,789,608Interest
                Expense
            
            
            4,041,679
            
            
            2,412,360
            
            
            1,297,978
            
            
            1,273,677
            
            
            1,173,985Provision
                for Loan Losses
            
            
            312,858
            
            
            251,048
            
            
            266,700
            
            
            146,379
            
            
            144,165Non-interest
                (Loss) Income
            
            
            (78,307
            )
            
            101,078
            
            
            121,637
            
            
            89,987
            
            
            74,049Non-Interest
                Expense
            
            
            1,550,840
            
            
            1,016,039
            
            
            929,365
            
            
            634,279
            
            
            516,431Net
                Income (Loss)
            
            
            160,568
            
            
            (44,315
            )
            
            (97,473
            )
            
            4,166
            
            
            29,076Per
                Common Share Data:Basic
                Earnings (Loss) Per Share(1)
            
            
            0.06
            
            
            (0.02
            )
            
            (0.04
            )
            
            -0-
            
            
            0.02Diluted
                Earnings (Loss) Per Share(2)
            
            
            0.06
            
            
            (0.02
            )
            
            (0.04
            )
            
            -0-
            
            
            0.01Dividends
                per share (1)
            
            
            0.08
            
            
            0.10
            
            
            0.15
            
            
            0.15
            
            
            0.13







(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.





**Year
                Ended December 31,****2006**
            
            **2005**
            
            **2004**
            
            **2003**
            
            **2002****Balance
                Sheet Data:**Cash
                and marketable securities
            
            $
            4,404,162
            
            $
            7,177,851
            
            $
            3,328,093
            
            $
            4,245,066
            
            $
            2,371,931Loans
                less allowance for loan losses
            
            
            54,704,020
            
            
            40,678,941
            
            
            20,144,798
            
            
            15,590,526
            
            
            15,830,293Real
                estate owned
            
            
            1,139,664
            
            
            802,815
            
            
            709,973
            
            
            1,014,254
            
            
            1,011,424Other
                assets(1)
            
            
            3,077,855
            
            
            2,110,938
            
            
            2,039,085
            
            
            2,280,217
            
            
            676,560Total
                assets
            
            
            63,325,701
            
            
            50,770,545
            
            
            26,221,949
            
            
            23,090,908
            
            
            19,890,208Notes
                payable
            
            
            61,774,343
            
            
            49,681,335
            
            
            24,817,403
            
            
            19,980,673
            
            
            17,482,519Participation
                loans
            
            
            -
            
            
            -
            
            
            107,248
            
            
            105,636
            
            
            1,077,730Other
                liabilities(2)
            
            
            133,044
            
            
            174,403
            
            
            101,446
            
            
            1,322,686
            
            
            358,902Total
                liabilities
            
            
            61,907,387
            
            
            49,855,738
            
            
            25,026,097
            
            
            21,408,995
            
            
            18,919,151Stockholders
                equity
            
            
            1,418,314
            
            
            914,807
            
            
            1,195,852
            
            
            1,681,913
            
            
            971,057**Other
                Financial Data:**Return
                on average assets(3)
            
            
            0.28
            %
            
            (0.12
            )%
            
            (0.40
            )%
            
            0.02
            %
            
            0.17
            %Return
                on average equity(4)
            
            
            13.76
            %
            
            (4.20
            )%
            
            (6.77
            )%
            
            0.31
            %
            
            3.32
            %Stockholders'
                equity to total assets
            
            
            2.04
            %
            
            1.81
            %
            
            4.56
            %
            
            7.28
            %
            
            5.1
            %Stockholders’
                equity to loans outstanding (5)
            
            
            2.59
            %
            
            2.25
            %
            
            5.94
            %
            
            10.79
            %
            
            6.13
            %**Loan
                Portfolio:**Principal
                funded during period
            
            $
            40,285,035
            
            $
            37,727,240
            
            $
            12,841,741
            
            $
            6,875,053
            
            $
            7,168,744Principal
                received during period
            
            $
            26,060,326
            
            $
            16,733,748
            
            $
            8,005,490
            
            $
            6,970,257
            
            $
            3,730,793Average
                interest rate for period
            
            
            11.05
            %
            
            10.66
            %
            
            10.89
            %
            
            10.74
            %
            
            11.00
            %Loan
                charge-offs as a percent of total portfolio at end of
                period
            
            
            0.46
            %
            
            0.35
            %
            
            1.38
            %
            
            0.75
            %
            
            0.94
            %**Investor
                Notes Payable:**Sale
                of notes during period
            
            $
            106,101,789
            
            $
            120,110,831
            
            $
            49,008,102
            
            $
            26,630,166
            
            $
            22,926,619Redemption
                of notes during period
            
            $
            95,933,794
            
            $
            96,630,099
            
            $
            44,786,895
            
            $
            24,697,770
            
            $
            18,681,654Average
                interest expense rate
            
            
            6.53
            %
            
            6.03
            %
            
            5.69
            %
            
            6.0
            %
            
            6.40
            %







(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 borrowings, accounts payable and
                accrued payroll liabilities, long-term lease liability, and escrows
                and
                security deposits.




-16-




(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, 2006 and 2005**




*Assets* .
      Total
      assets increased $12.56 million, or 24.74% to $63.33 million at December 31,
      2006, from $50.77 million at December 31, 2005. The size of the gross loan
      portfolio increased to $54.70 million from $40.68 million.




As
      of
      December 31, 2006 and 2005, non-accrual loans totaled $651,895 and $836,390,
      respectively. The decrease of $184,495 was due to the foreclosure of $342,137
      in
      non-accrual loans and the subsequent transfer of these properties to other
      real
      estate owned where they are being actively marketed for sale.




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





**2006**
            
            **2005**Non-accrual
                loans
            
            $
            651,895
            
            $
            836,390Foreclosed
                real estate held for sale
            
            
            325,223
            
            
            180,302Total
                non-performing assets
            
            $
            977,118
            
            $
            1,016,692Ratio
                of non-performing assets to:Total
                loans and foreclosed assets
            
            
            1.78
            %
            
            2.49
            %Total
                assets
            
            
            1.54
            %
            
            2.01
            %Loans
                90 days or more past due and still accruing interest
            
            $
            1,748,342
            
            $
            1,625,356Ratio
                of loans 90 days or more past due and still accruing to:Total
                loans
            
            
            3.19
            %
            
            4.00
            %Total
                assets
            
            
            2.76
            %
            
            3.21
            %




As
      of
      December 31, 2006 and 2005, there were loans of $1,748,342 and $1,625,356,
      respectively, more than ninety days past due on the books of the Company that
      continue to earn interest. These loans are well collateralized and the
      borrowers, in most cases, are making scheduled payments.




*Liabilities* .
      Total
      liabilities increased $12.05 million, or 24.16% to $61.91 million at December
      31, 2006, from $49.86 million at December 31, 2005. The increase was largely
      the
      result of the sale of additional investor Notes in the first part of 2006 and
      subsequent additions of accrued interest on the existing deposit
      accounts.




*Equity* .
      Total
      stockholders' equity increased to $1,418,314 or 55% in 2006 from $914,807 in
      2005 due to the current year net income, the additional sale and granting of
      our
      common stock and the increase in market value of our bond
      investments.




**Comparison
      of Operating Results for Years ended December 31, 2006 and
      2005**




The
      average yield earned on loans receivable increased to 11.05% in 2006 from 10.66%
      in 2005. The increase was due primarily to a general rise in interest rates
      during the year as a result of actions by the Federal Reserve.




The
      average rate paid on investor Notes increased to 6.53% in 2006 from 6.03% in
      2005. The net result was a slight decrease in net interest rate spread, which
      was 4.52% for 2006 as compared to 4.63% in 2005.




*Net
      Income (Loss)* .
      Net
      income for the year ended December 31, 2006 was $160,568 compared to a net
      loss
      of ($44,315) for the year ended December 31, 2005. The resulting profitability
      in 2006 was primarily due to net interest income increasing by $0.98 million
      even though we had non-interest loss of $0.08 million whereas we had
      non-interest income of $0.1 million in 2005.




*Interest
      Income* .
      Total
      interest income was $6.14 million in 2006 compared to $3.53 million in 2005.
      The
      additional interest income resulted primarily from the growth in our loan
      portfolio. The interest income for all periods includes point and fee income,
      interest earned on bank investments and marketable securities.




-17-




*Interest
      Expense* .
      Interest expense was $4.04 million in 2006, an increase from $2.41 million
      for
      2005. The additional expense resulted from a modest increase in investor notes
      outstanding during the period combined with an increase in the average rate
      paid
      on investor accounts to 6.53% in 2006 from 6.03% in 2005. The interest expense
      includes fees paid to broker-dealers.




*Provision
      for Loan Losses* .
      The
      provision for loan losses was $312,858 in 2006 and $251,048 in 2005. At year-end
      our non-accrual loans were $651,895 in 2006 and $836,390 in 2005 and our
      foreclosed real estate held for sale was $325,223 and $180,302, at those same
      respective dates. Our allowance for loan losses was $452,154 at the end of
      2006
      and $369,791 at the end of 2005. Relative to loan write-offs in 2006 of
      $230,495, our provision for loan losses of $312,858 [this does not match up]
      is
      about 136% of our write-offs.




*Non-Interest
      Income* .
      We had
      a non-interest loss of ($78,307) in 2006 and non-interest income of $101,078
      in
      2005. The loss in 2006 was principally the result of losses of ($156,482) from
      the sale of foreclosed properties.




*Non-Interest
      Expense* .
      Non-interest expense increased to $1,550,840 in 2006 from $1,016,039 in 2005.
      The increase was the result of increased salary expense, professional fees,
      real
      estate maintenance associated with foreclosed properties and increased office
      rent due to expanded facilities.





*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**




KH
      Funding Company's primary sources of capital are the proceeds from the sale
      of
      investor Notes, principal and interest payments on loans, sales of participation
      interests in loans and rental income. While maturities and scheduled
      amortization of loans and investments are predictable sources of funds, the
      sale
      of investor Notes and mortgage loan prepayments are 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.




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




**Year**
            
            **Notes
                Sold**
            
            **Notes
                Redeemed**
            
            **Percentage**2002
            
            $
            22,926,619
            
            $
            18,681,654
            
            
            81.47
            %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
            
            
            80.37
            %2006
            
            $
            106,101,789
            
            $
            95,933,794
            
            
            90.42
            %




The
      maturities of investor Notes at December 31, 2006 are as follows:





**Year
                Ending December 31,**2007
                (includes one-day and 30-day demand notes)
            
            $
            46,996,6062008
            
            
            4,891,4872009
            
            
            3,847,8742010
            
            
            2,348,1432011
            
            
            3,824,6062012
            
            
            28,608Subtotal
            
            $
            61,937,324Unamortized
                brokerage costs
            
            
            (162,981
            )Total
                investor Notes, net
            
            $
            61,774,343




*Investor
      Notes* .
      Management believes that the risk of not being able to fund redemption requests
      only exists if the requests for redemption exceed the amount of readily
      available cash, i.e., if our liquidity is insufficient to fund redemptions.
      Upon
      the sale of a Note, the funds for redemption are immediately available. Of
      course, part of our investment strategy is to invest proceeds of Note sales
      into
      higher yielding, less liquid investments, such as mortgages; nevertheless,
      the
      funds are still available, just not immediately. Only holders of one-day demand
      Notes can ask for funds sooner than 30 days, and we make an effort to keep
      funds
      available for these requests. Only holders of 30-day demand Notes can ask for
      funds sooner than 90 days, and if the funds will not be available within 30
      days, we will sell some of our mortgage loans to obtain the funds available
      to
      meet redemptions from these Note holders. All other types of notes, that is
      the
      term notes of one, three and five years, are redeemable upon maturity, or prior
      to maturity on 90 days advance notice, subject to a penalty. If necessary,
      we
      will sell loans in bulk to fund redemption requests from note
      holders **.** However,
      there is no assurance that such transactions will occur




-18-




The
      Company strives to maintain sufficient liquidity to meet all redemption
      requests. We normally hold 5% to 20% of our assets in cash and cash equivalents
      to fund redemptions of one-day demand Notes. This amount has historically been
      sufficient for us to meet our obligations. Also management believes that if
      required, we would be able to sell loans within 30 days to raise cash to meet
      redemption requests from 30-day demand Notes or within 90 days to meet early
      redemption requests from fixed term Note holders. Management believes that
      a
      portion of our loans could be sold to meet liquidity demands, if
      necessary.





Historically,
      redemption by holders of one-day demand Notes will not exceed 10% of one-day
      demand Notes balances on any given day or 30% of one-day demand Notes balances
      over any period of two weeks, and we maintain immediately available funds for
      such expected requests. For example, at December 31, 2006, we had outstanding
      $
      14.31 million of one-day demand Notes and $ 4.40 million in cash and cash
      equivalents. At December 31, 2005, we had outstanding $10.11 million of One
      Day
      Demand Notes and $6.58 million in cash and cash equivalents. In each instance,
      we had more funds available than necessary to fund historical levels of
      redemption requests.





*30-Day
      Demand Notes* .
      If
      there are not funds readily available to meet redemption requests from holders
      of 30-day demand Notes, we can sell some of our marketable securities or
      mortgage loans to have the funds available to meet requests for funds from
      holders of these Notes within 30 days. For example, in recent years we increased
      our holdings of marketable securities because they offered an attractive rate
      and complemented our investment strategy. The holders provided us with advance
      notice of their forthcoming redemption requests and we were able to sell some
      of
      our holdings of marketable securities in order to cover the requests. At
      present, 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.




Because
      we are buying and originating more loans that are readily saleable, we can
      keep
      less cash on hand but nevertheless have the ability to sell these loans and
      increase our cash position. At December 31, 2006 we held more than $9.0 million
      in loans that could be sold within a short period of time.




*One
      Year, Three Year and Five Year Fixed Term Notes* .
      All
      One, Three and Five Year Fixed Term Notes are redeemable upon maturity, or
      prior
      to maturity on 90 days advance notice, subject to a penalty. This provides
      us
      ample notice for redemptions and, if necessary, we can sell loans individually
      or in bulk to fund requests from holders of these Notes. For example, at
      December 31, 2006, we held $38.94 million in first trust residential and
      commercial property loans that could be sold in part, to a participant bank,
      or
      in whole, to other lenders. Further, we held $4.10 million in business
      line-of-credit loans and second trust loans which earn higher yields than the
      first trust loans and can also be sold, although they generally take longer
      to
      sell and are normally sold at a discount. The estimated market value of these
      loans exceeds the outstanding balance of One Day Demand and Thirty Day Demand
      Notes, under which the investor could request redemption at December 31, 2006
      of
      $ 31.92 million. See Note D of the Notes to our Financial Statements included
      in
      Item 7 of this Report.




*Plan
      to Raise Additional Funds* .
      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 capital 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 **.**




We
      also
      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.




*Use
      of Proceeds* .
      Net
      proceeds from Note offerings received by us 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
      will continue to expand this wholesale component of our operations and have
      it
      be a major part of our loan acquisition strategy.




-19-




We
      anticipate that our operations will shift to acquiring larger percentages of
      our
      loans at the wholesale level rather than interacting directly in the loan
      origination activities. This increased wholesale component will 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.




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.





*Redemption
      of Notes.* As
      disclosed under Item 1 “Business─Risk Factors,” we recently exercised our right
      to make a mandatory call of Notes from certain holders of Notes that are
      residents of states in which our offering was not currently registered or
      otherwise may not have been qualified under those states’ blue sky laws.
      Accordingly, we redeemed a total of $1.47 million in principal and interest
      amounts of Notes during late December 2006 and early January 2007. We have
      also
      offered to redeem Notes from holders in certain other states who hold an
      aggregate of $3.58 million in principal and interest amounts of Notes. Our
      offer
      to redeem Notes may only be declined by persons who are accredited investors
      that purchased a significant amount of investor Notes. The Company anticipates
      that it will redeem approximately $450,000 in principal amount of investor
      Notes
      from holders who do not qualify to decline the redemption offer in April 2007.
      We also anticipate that a small number of accredited investors who hold
      approximately $3.1 million of investor Notes, most of whom are affiliates of
      the
      Company or existing Note holders, will not elect rescission and will retain
      their investor Notes. We intend to use existing cash resources and principal
      and
      interest payments on our loan portfolio to satisfy any redemption requests
      and
      do not believe that we will need to liquidate any of our mortgage loan
      portfolio.




**Add
          discussion of cash flows from operating, investing and financing activities.
          See
          investing cash flows: “purchase of marketable securities” as adding cash?:
          discuss payments related to OREO of almost $500K**


Our
      principal sources of immediate liquidity are from cash and available for sale
      investments. Overall our cash dropped from by $2.8 million during 2006 while
      it
      increased by $3.9 million in 2005. As can be seen from our statement of cash
      flows the primary source of our funds received in 2006 and 2005 were from
      issuing our investor Notes. We received $106 and $120 million from issuing
      investor Notes, while we paid $96 and $97 million in Note redemptions, a
      comparable amount, in 2006 and 2005, respectively. The overall comparative
      drop
      in the amount of cash we received from this source was because of the fact
      that
      we sold investor notes in most of 2005 whereas because of the expiration of
      our
      public offering registration of our investor Notes, we generally only sold
      our
      Notes for the first four months of 2006.




**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 made by KH Funding to its borrowers. Unlike
      typical industrial companies, nearly all the assets and liabilities of KH
      Funding are monetary in nature. As a result, interest rates have a greater
      impact on KH Funding's financial performance than the effects of inflation
      generally have on the typical industrial companies.




-20-




**Critical
      Accounting Policies**




The
      Securities and Exchange Commission ("SEC") has issued guidelines on the
      disclosure of critical accounting policies. The SEC defines critical accounting
      policies as those 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 the footnotes to the financial
      statements. 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**





In
      February 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No.
      155, *“Accounting
      for Certain Hybrid Financial Instruments”* ,
      an
      amendment of SFAS No. 133 and SFAS No. 140. This statement permits fair value
      re-measurement for any hybrid financial instrument that contains an embedded
      derivative that otherwise would require bifurcation. It establishes 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. In
      addition, SFAS 155 clarifies which interest-only strips and principal-only
      strips are not subject to the requirements of Statement 133. It also clarifies
      that concentrations of credit risk in the form of subordination are not embedded
      derivatives. SFAS 155 amends Statement 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. This Statement is effective for all financial instruments acquired
      or issued after the beginning of an entity’s first fiscal year that begins after
      September 15, 2006. The Company does not presently have any derivative
      instruments and believes this new accounting standard will have no impact on
      its
      financial condition or results of operation.




In
      March
      2006, the FASB issued SFAS No. 156, *“Accounting
      for Servicing of Financial Assets”.* This
      Statement amends SFAS No. 140, *“Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Liabilities”* ,
      and
      requires that all separately recognized servicing assets and servicing
      liabilities be initially measured at fair value, if practicable, and permits
      the
      entities to elect either fair value measurement with changes in fair value
      reflected in earnings or the amortization and impairment requirements of SFAS
      No. 140 for subsequent measurement. The subsequent measurement of separately
      recognized servicing assets and servicing liabilities at fair value eliminates
      the necessity for entities that manage the risks inherent in servicing assets
      and servicing liabilities with derivatives to qualify for hedge accounting
      treatment and eliminates the characterization of declines in fair value as
      impairments or direct write-downs. This Statement is effective as of the
      beginning of an entity’s first fiscal year that begins after September 15, 2006.
      The Company believes that this new accounting standard will have no impact
      on
      its financial condition or results of operations.


In
        September 2006, the FASB issued SFAS No. 157, *Fair
        Value Measurements* (“SFAS
        No. 157”). This statement provides a single definition of fair value, a
        framework for measuring fair value, and expanded disclosures concerning fair
        value. Previously, different definitions of fair value were contained in
        various
        accounting pronouncements creating inconsistencies in measurement and
        disclosures. SFAS No. 157 applies under those previously issued pronouncements
        that prescribe fair value as the relevant measure of value, except SFAS No.
        123(R) and related interpretations and pronouncements that require or permit
        measurement similar to fair value but are not intended to measure fair value.
        This pronouncement is effective for fiscal years beginning after November
        15,
        2007. The Company is evaluating the impact of this new standard, but currently
        believes that adoption will not have a material impact on its financial
        position, results of operations, or cash flows.


-21-




In
      September 2006, the FASB issued SFAS No. 158, “Employer’s Accounting for Defined
      Benefit Pension and Other Postretirement Plans” (an amendment of FASB Statements
      No. 87, 88, 106, and 132R) (SFAS 158). SFAS 158 requires an employer to
      recognize in its statement of financial position an asset for a plan’s over
      funded status or a liability for a plan’s under funded status, measure a plan’s
      assets and its obligations that determine its funded status as of the end of
      the
      employer’s fiscal year (with limited exceptions), and recognize changes in the
      funded status of a defined benefit postretirement plan in the year in which
      the
      changes occur. Those changes will be reported in our comprehensive income and
      as
      a separate component of stockholders’ equity. SFAS 158 is effective for us in
      the fourth quarter of fiscal 2007. The Company does not offer any defined
      benefit retirement plans and therefore believes this new accounting standard
      will have no impact on its financial condition or results of operation.




In
      September 2006, the SEC’s Office of the Chief Accountant and Divisions of
      Corporation Finance and Investment Management released SAB No. 108, *Considering
      the Effects of Prior Year Misstatements when Quantifying Misstatements in
      Current Year Financial Statements* (“SAB
      No.
      108”), that provides interpretive guidance on how the effects of the carryover
      or reversal of prior year misstatements should be considered in quantifying
      a
      current year misstatement. The SEC staff believes that registrants should
      quantify errors using both a balance sheet and an income statement approach
      and
      evaluate whether either approach results in quantifying a misstatement that,
      when all relevant quantitative and qualitative factors are considered, is
      material. This pronouncement is effective for fiscal years ending after November
      15, 2006. In May 2005, the FASB issued SFAS No. 154, *Accounting
      Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB
      Statement No. 3* .
      This
      statement requires retrospective application to prior periods’ financial
      statements of changes in accounting principle, unless it is impracticable to
      determine either the period-specific effects or the cumulative effect of the
      change. In the case of impracticability in retrospective application, the
      statement gives guidance as to the appropriate treatment of the change or
      correction. The statement is effective for accounting changes made in fiscal
      years beginning after December 15, 2005. The adoption of this standard did
      not have a material impact on our financial condition, results of operations
      or
      liquidity.  Management
      believes the adoption of SAB No. 108 and SFAS No. 154 do not have a material
      impact on its financial position, results of operations, or cash flows.




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




**Index
      to Financial Statements**





**Report
                of Independent Registered Public Accounting Firm**
            
            
            23**Audited
                Financial Statements:**Balance
                Sheets as of December 31, 2006 and 2005
            
            
            24Statements
                of Operations for the years ended December 31, 2006 and
                2005
            
            
            25Statements
                of Changes in Stockholders' Equity for the years ended December 31,
                2006
                and 2005
            
            
            26Statements
                of Cash Flows for the years ended December 31, 2006 and
                2005
            
            
            27Notes
                to Financial Statements for the years ended December 31, 2006 and
                2005
            
            
            28-40





-22-




**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, 2006 and 2005, 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 its 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 KH Funding Company as of December
      31, 2006 and 2005, 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.




/s/
      Stegman & Company




Baltimore,
      Maryland


April
      4,
      2007




-23-


**KH
      Funding Company**




Balance
      Sheets as of December 31,





**2006**
            
            **2005*****Assets***Cash
            
            $
            3,823,013
            
            $
            6,579,242Investments
                available for saleMarketable
                securities - at fair value
            
            
            581,149
            
            
            598,609Other
            
            
            50,872
            
            
            50,872Loans,
                less allowance for loan losses of (2006) $452,154 and (2005)
                $369,791
            
            
            54,704,020
            
            
            40,678,941Accrued
                interest receivable
            
            
            1,961,683
            
            
            1,405,424Other
                receivables
            
            
            611,397
            
            
            126,269Prepaid
                expenses
            
            
            294,496
            
            
            374,762Property
                and equipment-net
            
            
            143,419
            
            
            137,623Real
                estate ownedRental
                property
            
            
            814,441
            
            
            622,513Held
                for sale
            
            
            325,223
            
            
            180,302Other
                assets
            
            
            15,988
            
            
            15,988**Total
                Assets**
            
            **$**
            **63,325,701**
            
            **$**
            **50,770,545*****Liabilities
                and Stockholders' Equity*****Liabilities**Notes
                and accrued interest payable
            
            $
            61,774,343
            
            $
            49,681,335Accounts
                payable and accrued expenses
            
            
            21,980
            
            
            2,730Escrows
                and security deposits
            
            
            111,064
            
            
            171,673**Total
                Liabilities**
            
            
            61,907,387
            
            
            49,855,738**Stockholders'
                Equity**Common
                stock(5,000,000
                shares authorized; 2,726,951 shares (2006) and 2,555,556 shares (2005),
                issued and outstanding; $0.01 par value)
            
            
            27,269
            
            
            25,556Paid-in
                capital
            
            
            1,879,783
            
            
            1,603,852Accumulated
                deficit
            
            
            (269,120
            )
            
            (429,688
            )Subscription
                note receivable
            
            
            (185,450
            )
            
            (185,450
            )Accumulated
                other comprehensive loss
            
            
            (34,168
            )
            
            (99,463
            )**Total
                Stockholders' Equity**
            
            
            **1,418,314**
            
            
            **914,807****Total
                Liabilities and Stockholders' Equity**
            
            **$**
            **63,325,701**
            
            **$**
            **50,770,545**




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


-24-


**KH
      Funding Company**




Statements
      of Operations for the years ended December 31,





**2006**
            
            **2005****Interest
                Income**Interest
                and fees on loans
            
            $
            5,983,972
            
            $
            3,389,674Interest
                on bank accounts
            
            
            129,314
            
            
            113,380Interest
                on investments-marketable securities
            
            
            30,966
            
            
            31,000Total
                interest income
            
            
            6,144,252
            
            
            3,534,054**Interest
                Expense**Interest
                and fees on notes
            
            
            4,041,679
            
            
            2,400,423Interest
                on participation loans
            
            
            -
            
            
            11,937Total
                interest expense
            
            
            4,041,679
            
            
            2,412,360Net
                interest income
            
            
            2,102,573
            
            
            1,121,694**Provision
                for Loan Losses**
            
            
            312,858
            
            
            251,048Net
                interest income after provision for loan losses
            
            
            1,789,715
            
            
            870,646**Non-interest
                (Loss) Income**Rental
                income
            
            
            55,822
            
            
            58,549(Loss)
                gain on sale of real estate owned
            
            
            (156,482
            )
            
            72,194Gain
                on sale of property and equipment
            
            
            2,500
            
            
            -Recognized
                loss on impairment of securities
            
            
            -
            
            
            (50,000
            )Other
            
            
            19,853
            
            
            20,335Total
                non-interest (loss) income
            
            
            (78,307
            )
            
            101,078**Non-interest
                Expense**Salaries
                and wages
            
            
            450,970
            
            
            326,602Professional
                fees
            
            
            218,541
            
            
            131,135Offering
                costs
            
            
            223,697
            
            
            199,121Administration
            
            
            112,946
            
            
            94,923Real
                estate maintenance
            
            
            232,407
            
            
            50,385Insurance
            
            
            75,739
            
            
            62,395Depreciation
            
            
            59,062
            
            
            50,387Rent
            
            
            118,359
            
            
            53,327Other
            
            
            59,119
            
            
            47,764Total
                non-interest expense
            
            
            1,550,840
            
            
            1,016,039**Net
                Income (Loss)**
            
            **$**
            **160,568**
            
            **$**
            **(44,315**
            **)**Basic
                earnings (loss) per share
            
            $
            0.06
            
            $
            (0.02
            )Diluted
                earnings (loss) per share
            
            $
            0.06
            
            $
            (0.02
            )Cash
                dividends paid per common share
            
            $
            0.08
            
            $
            0.10




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


-25-


**KH
      Funding Company**





Statements
      of Changes in Stockholders' Equity


For
      the
      years ended December 31, 2006 and 2005





**Common
                Stock**
            
            **Paid-in**
            
            **Accumulated**
            
            **Subscription
                Note**
            
            **Accumulated
                Other Comprehensive**
            
            **Total
                Stockholders'****Shares**
            
            **Amount**
            
            **Capital**
            
            **Deficit**
            
            **Receivable**
            
            **(Loss)
                Income**
            
            **Equity****Balance
                at January 1, 2005**
            
            
            2,505,556
            
            $
            25,056
            
            $
            1,750,443
            
            $
            (385,373
            )
            $
            (185,450
            )
            $
            (8,824
            )
            $
            1,195,852**Stock
                Options Exercised**
            
            
            50,000
            
            
            500
            
            
            99,500
            
            
            
            
            
            
            
            
            
            
            
            100,000**Dividends
                Declared $.10 per share**
            
            
            
            
            
            
            
            
            (246,091
            )
            
            
            
            
            
            
            
            
            
            
            (246,091
            )**Comprehensive
                Income**Net
                loss for the year ended December 31, 2005
            
            
            
            
            
            
            
            
            
            
            
            (44,315
            )
            
            
            
            
            
            
            
            (44,315
            )Change
                in fair value of investments
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (90,639
            )
            
            (90,639
            )**Total
                Comprehensive Income**
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (134,954
            )**Balance
                at December 31, 2005**
            
            
            2,555,556
            
            
            25,556
            
            
            1,603,852
            
            
            (429,688
            )
            
            (185,450
            )
            
            (99,463
            )
            
            914,807**Stock
                Redeemed**
            
            
            (3,000
            )
            
            (30
            )
            
            (7,170
            )
            
            
            
            
            
            
            
            
            
            
            (7,200
            )**Additional
                Stock Sold**
            
            
            121,495
            
            
            1,214
            
            
            363,270
            
            
            
            
            
            
            
            
            
            
            
            364,484**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




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


-26-


**KH
      Funding Company**





Statements
      of Cash Flows


For
      the
      years ended December 31,





**2006**
            
            **2005****Cash
                from Operating Activities:**Net
                income (loss)
            
            $
            160,568
            
            $
            (44,315
            )**Adjustments
                to reconcile net income to net cash from operating
                activities:**Depreciation
            
            
            59,063
            
            
            50,387Amortization
                of loan fees
            
            
            (175,234
            )
            
            (61,873
            )Provision
                for loan losses
            
            
            312,858
            
            
            251,048Share-based
                compensation expense
            
            
            54,700
            
            
            -Loss
                (gain) on sale of real estate owned
            
            
            156,482
            
            
            (72,194
            )Gain
                on sale of property and equipment
            
            
            2,500
            
            
            -Recognized
                loss on impairment of investment real estate
            
            
            155,659
            
            
            50,000Recovery
                of prior loan receivable write-off
            
            
            -
            
            
            6,500**Changes
                in operating assets and liabilities:**Increase
                in accrued late charges
            
            
            (22,955
            )
            
            8,148Prepaid
                expenses
            
            
            (178,135
            )
            
            39,417Interest
                receivable
            
            
            (550,182
            )
            
            (545,899
            )Interest
                payable (included in notes payable)
            
            
            1,960,572
            
            
            1,317,000Accounts
                payable and accrued expenses
            
            
            19,250
            
            
            830Accrued
                Interest on investments
            
            
            (6,077
            )
            
            (6,077
            )Prepaid
                offering costs
            
            
            258,401
            
            
            32,616Deferred
                loan origination costs
            
            
            (16,862
            )
            
            (27,934
            )Unamortized
                brokerage fees
            
            
            (35,559
            )
            
            (77,371
            )Prepaid
                loan expenses
            
            
            (223,314
            )
            
            (158,361
            )****Other
                assets
            
            
            -
            
            
            (6,185
            )**Net
                Cash provided by Operating Activities**
            
            
            1,931,735
            
            
            755,737**Cash
                Flows from Investing Activities:**Principal
                repayments from borrowers
            
            
            26,060,326
            
            
            16,733,748Loans
                made to borrowers
            
            
            (31,651,635
            )
            
            (33,095,439
            )Purchase
                of loans
            
            
            (8,633,400
            )
            
            (4,473,440
            )Redemption
                (purchase) of marketable securities andother
                investments
            
            
            82,755
            
            
            (31,000
            )Proceeds
                from sale of marketable securities and other investments
            
            
            -
            
            
            58,000Payments
                for other receivables
            
            
            (440,536
            )
            
            411,468Purchase
                of property and equipment
            
            
            (44,541
            )
            
            (129,716
            )Proceeds
                from sale of real estate owned
            
            
            143,927
            
            
            266,076Payments
                related to real estate owned (purchases and improvements)
            
            
            (490,598
            )
            
            (29,128
            )**Net
                Cash Used in Investing Activities**
            
            
            (14,973,702
            )
            
            (20,289,431
            )**Cash
                Flow from Financing Activities:**Proceeds
                from investor notes
            
            
            106,101,789
            
            
            120,188,202Principal
                payments on investor notes
            
            
            (95,933,794
            )
            
            (96,630,099
            )Proceeds
                from sales of common stock
            
            
            444,484
            
            
            100,000Decrease
                in participation loans
            
            
            -
            
            
            (107,248
            )Payment
                of dividends
            
            
            (214,340
            )
            
            (246,091
            )Redemption
                of common stock
            
            
            (7,200
            )
            
            -(Decrease)
                Increase in escrow and security deposits payable
            
            
            (105,201
            )
            
            138,327**Net
                Cash Provided by Financing Activities**
            
            
            10,285,738
            
            
            23,443,091**Net
                (Decrease) Increase in Cash**
            
            
            (2,756,229
            )
            
            3,909,397**Cash
                Balance**,
                beginning of year
            
            
            6,579,242
            
            
            2,669,845**Cash
                Balance**,
                end of year
            
            $
            3,823,013
            
            $
            6,579,242**Supplemental
                cash flows information:**Interest
                paid
            
            $
            2,081,077
            
            $
            1,095,360Transfer
                of loans to other real estate owned
            
            $
            325,137
            
            $
            283,460





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


-27-


**KH
        Funding Company**
  Notes
        to
        Financial Statements
 *For
        the Years Ended December 31, 2006 and 2005*


**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 2005 financial statements to conform
      with
      the 2006 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.





-28-


**KH
        Funding Company**
  Notes
        to
        Financial Statements
 *For
        the Years Ended December 31, 2006 and 2005*


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.





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 5 years. Based on this percentage loss
      history, the Company sets aside 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.




-29-


**KH
        Funding Company**
  Notes
        to
        Financial Statements
 *For
        the Years Ended December 31, 2006 and 2005*


***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. 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 for rental
      property 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 notes payable to our customers. Some notes are sold
      directly to note holders and many are sold through brokers. 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 shareholders. Therefore, no provision for income
      taxes
      is necessary in the financial statements.




***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 and
      361,250 options have been excluded for 2006 and 2005, respectively, as their
      effect is antidilutive.





**Year
                Ended December 31,****2006**
            
            **2005**Basic:Net
                income (loss) (attributable to common stock)
            
            $
            160,568
            
            $
            (44,315
            )Average
                common shares outstanding
            
            
            2,684,454
            
            
            2,505,693Basic
                earnings (loss) per share
            
            $
            0.06
            
            $
            (0.02
            )Diluted:Net
                income (loss) (attributable to common stock)
            
            $
            160,568
            
            $
            (44,315
            )Average
                common shares outstanding
            
            
            2,684,454
            
            
            2,505,693Dilutive
                effect of stock options
            
            
            101,892
            
            
            -Average
                common shares outstanding - diluted
            
            
            2,786,346
            
            
            2,505,693Diluted
                earnings (loss) per share
            
            $
            0.06
            
            $
            (0.02
            )




***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.




-30-


**KH
        Funding Company**
  Notes
        to
        Financial Statements
 *For
        the Years Ended December 31, 2006 and 2005*


Prior
      to
      January 1, 2006, the Company applied the intrinsic value method of accounting
      as
      prescribed by Accounting Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* (“APB
      25”), with pro forma disclosure of the impact on net income (loss) of using the
      fair value option expense recognition method. Under the intrinsic value method,
      compensation cost is the excess, if any, of the market price of the stock at
      the
      grant date over the option exercise price. In the past it has been the Company’s
      policy to grant options to employees that vest immediately and consequently,
      the
      entire expense, if recognized, would have been recognized in the period granted.
      The valuation of the fair value option expense was calculated under the original
      provisions of the original SFAS 123, *Accounting
      for Stock-Based Compensation* ,
      as
      described in out previous filings.





The
      following table illustrates the effect on net income and earnings per share
      if
      the Company had applied the fair value recognition provisions of the original
      SFAS 123 to options granted under the Company's stock option plan for the year
      ended December 31, 2005. For the purposes of this pro forma disclosure, the
      value of the options was estimated using the Minimum Value Method assuming
      a
      risk-free rate of 3.75%, a 5-year expected life, and a dividend payout of $0.08
      per year paid quarterly. A volatility value of zero was used as the Company's
      shares are not publicly listed or traded.


Year
                Ended
              December
                31, 2005Net
                loss, as reported
            
            $
            (44,315
            )Deduct:
                Total stock-based employee compensationexpense
                determined under fair value basedmethod
                for all awards
            
            
            (55,046
            )Pro
                forma net loss
            
            $
            (99,361
            )Loss
                per common share:Basic
                - as reported
            
            $
            (0.02
            )Basic
                - pro forma
            
            $
            (0.04
            )Diluted
                - as reported
            
            $
            (0.02
            )Diluted
                - pro forma
            
            $
            (0.04
            )




***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.




-31-


**KH
        Funding Company**
  Notes
        to
        Financial Statements
 *For
        the Years Ended December 31, 2006 and 2005*


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




Investment
      securities available for sale consists of the following at December
      31:


2006Gross
                
                GrossAmortized
                
                Unrealized
                
                Unrealized
                
                EstimatedCost
                
                Gains
                
                Losses
                
                Fair
                    ValueCorporate
                    Bonds
                
                $
                615,317
                
                $
                -
                
                $
                (34,168
                )
                $
                581,149Other
                
                
                -
                
                
                -
                
                
                -
                
                
                -Totals
                
                $
                615,317
                
                $
                -
                
                $
                (34,168
                )
                $
                581,149
 
 2005Gross
                
                GrossAmortized
                
                Unrealized
                
                Unrealized
                
                EstimatedCost
                
                Gains
                
                Losses
                
                Fair
                    ValueCorporate
                    Bonds
                
                $
                623,351
                
                $
                -
                
                $
                (99,463
                )
                $
                523,888Other
                
                
                74,721
                
                
                -
                
                
                -
                
                
                74,721Totals
                
                $
                698,072
                
                $
                -
                
                $
                (99,463
                )
                $
                598,609


All
      of
      the corporate bonds outstanding at December 31, 2006 mature in between one
      and
      five years.




Securities
      with unrealized losses, segregated by length of impairment at December 31,
      2006
      were as follows:


Less
                    than 12 Months
              
              More
                    than 12 Months
              
              TotalEstimated
              
              Unrealized
              
              Estimated
              
              Unrealized
              
              Estimated
              
              UnrealizedFair
                  Value
              
              Losses
              
              Fair
                  Value
              
              Losses
              
              Fair
                  Value
              
              LossesCorporate
                  Bonds
              
              $
              -
              
              $
              -
              
              $
              581,149
              
              $
              34,168
              
              $
              581,149
              
              $
              34,168Other
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Totals
              
              $
              -
              
              $
              -
              
              $
              581,149
              
              $
              34,168
              
              $
              581,149
              
              $
              34,168




Declines
      in the fair value of available-for-sale securities below their cost are not
      deemed to be other than temporary. In estimating other-than-temporary impairment
      losses, management considers, among other things, (i) the length of time and
      the
      extent to which the fair value has been less than cost, (ii) the financial
      condition and near-term prospects of the issuer, and (iii) the intent and
      ability of the Company to retain its investment in the issuer for a period
      of
      time sufficient to allow for any anticipated recovery in fair value. Given
      all
      of these factors we have determined that the loss on these above corporate
      bonds, those of two fortune 500 industrial companies, are temporary in nature
      because of the quality of the bonds and the our ability and internt to hold
      the
      investments to recover in fair market value.




No
      marketable securities were sold in either the year ended December 31, 2006
      or
      2005.




-32-


**KH
          Funding Company**
  Notes
          to
          Financial Statements
 *For
          the Years Ended December 31, 2006 and 2005*


**NOTE
      C—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
      2005, the Company determined that one of these investments was worthless and
      recognized an impairment loss of $50,000. In 2005 there was a partial-redemption
      of the only remaining investment in the amount of $58,000.




The
      carrying value of Other Investments, consisting of one investment, was $50,872
      at December 31, 2006 and 2005.




**NOTE
      D—LOANS RECEIVABLE**






Loans
      receivable consist of 220 collateralized loans and 9 uncollateralized loans
      for
      2006 and 244 collateralized loans and 9 uncollateralized loans for 2005. The
      loans receivable originate from various individuals and businesses ranging
      in
      balance from $599 to $2,718,081 for 2006 and $501 to $2,600,000 for 2005,
      bearing interest rates ranging from 3.99 percent to 24 percent in 2006 and
      from
      1.5 percent to 24 percent in 2005, with a weighted-average yield of 11.05
      percent and 10.66 percent, respectively. Uncollateralized loans constitute
      approximately 0.4 percent and 0.8 percent of the gross loan value at December
      31, 2006 and 2005, respectively.




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 $180,388 and $154,530 at December 31, 2006 and 2005,
      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. The costs which were unamortized were $388,089 and $164,774 at December
      31, 2006 and 2005, 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 $44,796
      and
      $27,934 at December 31, 2006 and 2005, respectively.




-33-


**KH
      Funding Company**




Notes
      to
      Financial Statements


*For
      the Years Ended December 31, 2006 and 2005*




***Loans
      Receivable by Collateral Type***




The
      Company's loans receivable portfolio consists of the following by type of loans
      at December 31:





**2006**
            
            **2005****Primary
                Collateral Type**
            
            **Amount**
            
            **Amount**Residential
                Real Estate First Trust
            
            $
            15,403,919
            
            $
            6,801,401Business
                Assets and Commercial Real Estate First Trust
            
            
            2,948,930
            
            
            5,159,408Residential
                Investment Property First Trust
            
            
            33,023,531
            
            
            24,557,184Residential
                Real Estate Second Trust
            
            
            1,153,487
            
            
            2,103,760Other
                Assets (Auto, Stock)
            
            
            1,978,712
            
            
            2,035,215Other
                Loans (Over Equity, Medical and Unsecured)
            
            
            407,751
            
            
            441,843Total
                loans receivable, gross
            
            
            54,916,330
            
            
            41,098,810Unearned
                fees and other
            
            
            239,844
            
            
            (50,078
            )Less
                allowance for loan losses
            
            
            (452,154
            )
            
            (369,791
            )Total
                loans receivable, net
            
            $
            54,704,020
            
            $
            40,678,941




Maturities
      as of December 31, 2006, are as follows:





**Year
                Ending December 31,**2007
            
            $
            30,045,8442008
            
            
            5,848,3752009
            
            
            1,737,3542010
            
            
            2,363,1012011
            
            
            4,164,8502012
                and thereafter
            
            
            10,756,806Total
                loans receivable, gross
            
            $
            54,916,330




The
      fair
      value of the gross loans receivable is estimated to be $54,885,547 and
      $40,998,847 at December 31, 2006 and 2005, 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, 2006 the Company had outstanding loan balances to one borrower
      and
      its affiliated entities of $8,682,933 which represented 15.87% of loans
      outstanding at that date. Management believes that this concentration is
      adequately collateralized with first deeds of trust on related real
      estate.




We
      issue
      lines-of-credit or draw-type loans. At December 31, 2006 we had $16.3 million
      in
      loans of this type. The unused or unfunded amount on these types of loans
      totaled $ 3.42
      million at that date. This amount represents approved loan dollars which
      borrowers may use at their discreation.




-34-


**KH
          Funding Company**
  Notes
          to
          Financial Statements
 *For
          the Years Ended December 31, 2006 and 2005*


***Analysis
      of Loan Loss Reserves***




Analysis
      of the allowance for loan loss is as follows:





**Year
                Ending December 31,**
            
            **2006**
            
            **2005**Beginning
                balance
            
            $
            369,791
            
            $
            233,311Provision
                for loan losses
            
            
            312,858
            
            
            251,048Loans
                charged off
            
            
            (230,495
            )
            
            (121,068
            )Recovery
                of loans previously charged off
            
            
            -
            
            
            6,500Ending
                balance
            
            $
            452,154
            
            $
            369,791




Loans
      in
      non-accrual status totaled $651,895 and $836,390 at December 31, 2006 and 2005,
      respectively.




As
      of
      December 31, 2006 and 2005, the Company had loans of $1,748,342 and $1,625,356,
      respectively, which were more than ninety days late and for which the Company
      continues to accrue interest. The Company has collateral for these loans and
      management believes that both the principal and the related accrued interest
      is
      collectible.





**12/31/06**
            
            **12/31/05**Total
                recorded investment in impaired loans at the end of the
                period
            
            $
            651,895
            
            $
            836,390Amount
                of that recorded investment for which there is a related allowance
                for
                credit losses
            
            $
            631,289
            
            $
            836,390Amount
                of related allowance for credit losses associated with such
                investment
            
            $
            285,316
            
            $
            228,493Amount
                of that recorded investment for which there is no related allowance
                for
                credit losses
            
            $
            20,606
            
            $
            -




**12/31/06**
            
            **12/31/05**The
                average recorded investment in impaired loans during the
                period
            
            $
            744,142
            
            $
            709,871The
                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
      E—PROPERTY AND EQUIPMENT**




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





**2006**
            
            **2005**Furniture
                and equipment
            
            $
            84,335
            
            $
            82,302Automobiles
            
            
            26,671
            
            
            27,074Computer
                software
            
            
            93,979
            
            
            80,642Leasehold
                improvements
            
            
            18,813
            
            
            18,813223,798
            
            
            208,831Less:
                Accumulated depreciation
            
            
            80,379
            
            
            71,208Property
                and equipment - net
            
            $
            143,419
            
            $
            137,623




Depreciation
      expense related to property and equipment for the years ended December 31,
      2006
      and 2005, totaled $36,245 and $25,848, respectively.




-35-


**KH
          Funding Company**
  Notes
          to
          Financial Statements
 *For
          the Years Ended December 31, 2006 and 2005*


**NOTE
      F—REAL ESTATE OWNED**




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





**2006**
            
            **2005**Rental
                property:Buildings
            
            $
            550,686
            
            $
            625,301Less:
                Accumulated Depreciation
            
            
            46,375
            
            
            70,538504,311
            
            
            554,763Land-rental
                property
            
            
            310,130
            
            
            67,750Total
                rental
            
            $
            814,441
            
            $
            622,513Held
                for Sale:Buildings
            
            $
            264,473
            
            $
            155,302Land
            
            
            60,750
            
            
            25,000Total
                held for sale
            
            $
            325,223
            
            $
            180,302




Depreciation
      expense related to rental property for the years ended December 31, 2006 and
      2005, totaled $22,817 and $24,539, respectively.




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




Information
      related to notes payable at December 31, 2006 and 2005 is as
      follows:





**2006**
            
            **2005**Number
                of notes payable
            
            
            1,876
            
            
            1,310Highest
                balance
            
            $
            1,997,804
            
            $
            3,589,022Lowest
                balance
            
            $
            8
            
            $
            2Lowest
                interest rate
            
            
            4.00
            %
            
            4.00
            %Highest
                interest rate
            
            
            9.15
            %
            
            9.25
            %Weighted
                average interest rate
            
            
            6.53
            %
            
            6.03
            %Number
                of accounts greater than $100,000
            
            
            137
            
            
            104Value
                of accounts over $100,000
            
            $
            33,732,440
            
            $
            27,960,681




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





**Year
                Ending December 31,**2007
            
            $
            46,996,6062008
            
            
            4,891,4872009
            
            
            3,847,8742010
            
            
            2,348,1432011
            
            
            3,824,6062012
            
            
            28,608Subtotal
            
            $
            61,937,324Unamortized
                brokerage costs
            
            
            (162,981
            )Total
                Notes and accrued interest payable
            
            $
            61,774,343




The
      maturity date is considered to be the date on which the note first becomes
      a
      demand note. Included in the due in 2007 category is $14,175,245 on one-day
      demand accounts, which the creditor can immediately withdraw and $17,671,598
      that requires a 30-day notice before withdrawal can be made.




-36-





**KH
      Funding Company**




Notes
      to
      Financial Statements


*For
      the Years Ended December 31, 2006 and 2005*




The
      Company has three classes of notes payable, Series II, III and IV notes. Series
      II notes were sold in private offerings by the Company from inception through
      November 2, 2003. On November 3, 2003 the Company registered a Public Offering
      with the Securities and Exchange Commission. Subsequent to the November 3,
      2003
      offering the Company registered secondary Public Offerings with the Securities
      and Exchange Commission on August 2, 2004 and July 15, 2005. The Series III
      and
      IV notes were sold under the public offerings. The Series III 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 IV notes join the Series II notes in right
      of
      payment and both are subordinate to senior debt of the Company.




As
      of
      December 31, 2006, notes payable outstanding by class of securities is as
      follows:





Series
                II
            
            
            Privately
                issued subordinated debt
            
            $
            3,480,015Series
                III
            
            
            Publicly
                issued senior debt
            
            
            51,651,444Series
                IV
            
            
            Publicly
                issued subordinated debt
            
            
            6,805,865Subtotal
            
            
            
            
            
            61,937,324Unamortized
                brokerage costs
            
            
            
            
            
            (162,981
            )Total
                Notes and accrued interest payable
            
            
            
            
            $
            61,774,343




The
      Company's notes are sold directly to note holders and also 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 $162,981 and $127,421 at December
      31, 2006 and 2005, respectively.




For
      the
      year ended December 31, 2006 and 2005, interest expense totaled **$4,041,679
      and $2,412,360** ,
      respectively, and interest paid totaled **$2,081,077
      and $1,095,360** ,
      (these
      do not agree to c/f stmt.) respectively.




**NOTE
      H—RELATED PARTY TRANSACTIONS**




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




·
            Included
                in loans receivable at December 31, 2006 and 2005, are 14 notes and
                11
                notes totaling $9,571,428 and $4,274,751, respectively, from officers,
                stockholders and a company controlled by an stockholder. The interest
                rates on these notes range between 5.99% and
                12.5%.




·
            Included
                in the notes payable at December 31, 2006 and 2005, are 63 and 59
                notes
                totaling $7,421,423 and $5,935,165, respectively, which are held
                by
                officers and shareholders. 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 $52,000 and a fair value of about
                $300,000
                as of December 31, 2006. At December 31, 2006 and 2005, 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 amount of $8.46
      million to a trust for the benefit of a significant shareholder. 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
      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 KH
      Funding is to receive one quarter or one-half, depending on the specific
      property, of any gain after adjusting for certain costs and commissions. The
      loans do not have any variable down-side features which would cause interest
      to
      be lower than the stated rate on each loan. Under the terms of the loans any
      refinancing or sale of the properties must be approved by the KH Funding in
      advance. During the year ended December 31, 2006, the Company recognized
      $ 80,445 in
      additional interest from the above loan features. KH Funding recognizes such
      additional interest earned through variable up-side loan features only when
      the
      additional interest is collected.




-37-


**KH
        Funding Company**
  Notes
        to
        Financial Statements
 *For
        the Years Ended December 31, 2006 and 2005*


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




***Stock
      Option Plans***




The
      Company has granted stock options to employees, shareholders and board members.
      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.




During
      fiscal year 2000, the Company granted options to purchase 50,000 shares of
      common stock at $2.00 per share in connection with the issuance of a note
      payable. These options were exercised in 2005. During 2005, the Company granted
      options to purchase 100,000 shares of common stock at $2.25 per share. In 2006,
      100,000 options to purchase common stock were issued at $3.00 per share and
      50,000 options 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. The following depicts option activity for the years ended December
      31, 2006 and 2005:





**Number
                of**
              **Shares**
            
            **Weighted-Average
                Exercise Price**
            
            **Aggregate
                Intrinsic Value**Options
                outstanding at January 1, 2005
            
            
            311,250
            
            $
            2.00Options
                granted-2005
            
            
            100,000
            
            
            2.25Options
                expired-2005
            
            
            -
            
            
            -Options
                exercised-2005
            
            
            (50,000
            )
            
            2.00Options
                outstanding at December 31, 2005
            
            
            361,250
            
            
            2.07
            
            $
            335,963Options
                granted-2006
            
            
            150,000
            
            
            3.10
            
            
            -Options
                expired-2006
            
            
            -
            
            
            -
            
            
            -Options
                exercised-2006
            
            
            (40,000
            )
            
            2.00
            
            $
            40,000Options
                outstanding at December 31, 2006
            
            
            471,250
            
            $
            2.40
            
            $
            282,750





At
      December 31, 2006 321,250 of the Company's outstanding options were exercisable.
      The weighted average exercise price of these options is $2.08 and the weighted
      average remaining contractual life in years is 2.45. The remaining 150,000
      stock
      options vest over a period of three years and are fully vested at July 10,
      2009.
      The combined weighted average exercise price for the total 471,250 options
      outstanding at December 31, 2006 was $2.40. One hundred fifty thousand options
      were granted under the 2005 Incentive Stock Option Plan. All of the other
      options outstanding were granted outside of any shareholder approved Stock
      Option Plan of the Company.




A
      summary
      of stock options outstanding and exercisable at December 31, 2006 by exercise
      price is as follows:


Weighted
                    AverageRemainingNumber
                
                Contractual
                    Life
                
                NumberExercise
                    Price
                
                Outstanding
                
                (
                    in years)
                
                Exercisable$
                2.00
                
                
                221,250
                
                
                2.12
                
                
                221,250$
                2.25
                
                
                100,000
                
                
                3.06
                
                
                100,000$
                3.00
                
                
                100,000
                
                
                4.54
                
                
                -$
                3.30
                
                
                50,000
                
                
                4.54
                
                
                -471,250
                
                
                
                
                
                321,250




-38-


**KH
          Funding Company**
  Notes
          to
          Financial Statements
 *For
          the Years Ended December 31, 2006 and 2005*


The
      weighted fair value of options granted during December 31, 2006 and 2005 was
      $0.61 and $0.55, respectively.




The
      fair
      value of options granted was calculated using the Black-Scholes option pricing
      model. A total of 150,000 options, which vest ratably each year over a 3 year
      period, were granted to employees in the year ended December 31,
      2006 **.** These
      options gave rise to a $16,000 charge to income in 2006. The amount of
      approximately $75,000 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
      three and nine month periods ending September 30, 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 also to non-independent board members (for
      their board service).for the year ended December 31, 2006 totaled $38,700,
      or
      $18,600 and 20,100, respectively.




**NOTE
      J—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, 2006:





**Year
                Ending December 31,**2007
            
            $
            98,4882008
            
            
            102,4262009
            
            
            106,5222010
            
            
            110,7842011
            
            
            115,208Thereafter
            
            
            485,602Total
            
            $
            1,019,030




Rent
      expense under operating leases totaled $118,359 and $53,327 for the years ended
      December 31, 2006 and 2005, respectively.




**NOTE
      K—LOAN PARTICIPATION AND LOAN COMMITMENTS**




While
      the
      Company had some participation loan activity during 2005, it had none during
      2006.




Credit
      commitments are agreements make loans to borrowers in the ordinary course of
      business. We do not have such agreements. However, we do make line-of-credit
      type loans which enable borrowers to draw down on their approved loan as needed.
      At December 31, 2006 we had $16.3 million in
      loans
      of this type. Loans of this type had unused or unfunded approved amount of
      $3.42
      million at that date.




-39-


**KH
          Funding Company**
  Notes
          to
          Financial Statements
 *For
          the Years Ended December 31, 2006 and 2005*


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
      notes payable of the Company. 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. We underwent a review in 2005 and
      are not aware of any issues resulting from such review.





**Year
                Ending December 31,**
            
            **2006**
            
            **2005**Total
                Assets under Trust
            
            $
            7,785,921
            
            $
            5,417,337Portion
                of Assets Invested in KH Funding Notes Payable
            
            $
            7,206,921
            
            $
            5,342,337Portion
                of Assets Invested in Outside Investments
            
            $
            579,000
            
            $
            75,000




**NOTE
      L—LOAN
      CONCENTRATIONS**




The
      Company makes loans to a number of different business and individuals; however,
      it does have a concentration of loans either directly with or indirectly with
      two of its shareholders. The Company has approximately $8.68 million or 15%
      of
      its loans and interest receivable directly or indirectly with one shareholder
      or
      entities owned at least to some extent by that shareholder at December 31,
      2006.
      The Company also purchases loans from a company owned by another one of its
      shareholders. Approximately $11.80 million or 21% of the Company’s loans and
      interest receivable are loans of this type at December 31, 2006. 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.





**ITEM
              7.**
            **CHANGES
                IN AND DISAGREEMENTS WITH ACCOUNTANTS ON****ACCOUNTING
                AND FINANCIAL DISCLOSURE**




None.




**ITEM
              7B.**
            **CONTROLS
                AND PROCEDURES**




*Evaluation
      of Disclosure Controls and Procedures* .
      The
      Company's management is responsible for establishing and maintaining a system
      of
      disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e)
      under the Exchange Act) that is designed to ensure that information required
      to
      be disclosed by the Company in the reports that the Company files or submits
      under the Exchange Act is recorded, processed, summarized and reported, within
      the time periods specified in the Commission's rules and forms. Disclosure
      controls and procedures include, without limitation, controls and procedures
      designed to ensure that information required to be disclosed by an issuer in
      the
      reports that it files or submits under the Securities Exchange Act of 1934
      (the
      "Exchange Act") is accumulated and communicated to the issuer's management,
      including its principal executive officer or officers and principal financial
      officer or officers, or persons performing similar functions, as appropriate
      to
      allow timely decisions regarding required disclosure.




Our
      Chief
      Executive Officer and Chief Financial Officer have evaluated the effectiveness
      of the design and operation of our disclosure controls and procedures in
      accordance with Rule 15d-15 of the Exchange Act. Based on their evaluation,
      the
      Chief Executive Officer and Chief Financial Officer concluded that, as of the
      end of the period covered by this report, our disclosure controls and procedures
      were effective to provide reasonable assurance that information required to
      be
      disclosed in the Company's reports filed or submitted under the Exchange Act
      is
      recorded, processed, summarized and reported in a timely manner the information
      required to be disclosed in reports we file under the Exchange Act.




-40-


**KH
          Funding Company**
  Notes
          to
          Financial Statements
 *For
          the Years Ended December 31, 2006 and 2005*


*Changes
      in Internal Controls* .
      No
      change in our internal control over financial reporting occurred during our
      fourth quarter of 2006 that has materially affected, or is reasonably likely
      to
      materially affect, our internal control over financial reporting.




*Limitations
      on the Effectiveness of Controls* .
      KH
      Funding's management, including the Chief Executive Officer and Chief Financial
      Officer, does not expect that its disclosure or internal controls will prevent
      all errors or fraud. 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. Because of
      the
      inherent limitations in a cost-effective control system, misstatements due
      to
      error or fraud may occur and not be detected.




**ITEM
      7C.**  **OTHER
      INFORMATION**




None.




-41-




**PART
      III**




**ITEM
      8.**  **DIRECTORS,
      EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION
      16(A)
      OF THE EXCHANGE ACT**




*Directors
      and Executive Officers* .
      The
      following is the name, age and position of each of our current directors and
      executive officers as of December 31, 2006:





**Name**
            
            **Age**
            
            **Position(s)**Robert
                L. Harris
            
            57
            
            Chief
                Executive Officer, President and DirectorLouise
                B. Sehman
            
            72
            
            SecretaryJames
                E. Parker
            
            58
            
            Chief
                Financial OfficerRonald
                L. Nicholson
            
            52
            
            Vice
                President - Accounts and Loan AdministrationMartin
                Angeli
            
            43
            
            Senior
                Vice President - SalesJack
                H. Breskow*
            
            77
            
            DirectorDr.
                Mervyn Feldman*
            
            72
            
            DirectorAlvin
                Shapiro*
            
            75
            
            DirectorJeremiah
                P. Connor*
            
            67
            
            Director







*  Asterisks
      denote individuals who we believe are "independent directors" as that term
      is
      defined by the listing standards of the American Stock Exchange.




Robert
      L.
      Harris 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. 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 in the state of Maryland.




Louise
      B.
      Sehman joined KH Funding Company in 1992. She currently serves as the Secretary
      of KH Funding. 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.




James
      E.
      Parker joined KH Funding Company in 1997. He currently serves as the Chief
      Financial Officer. 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. Mr. Parker became Chief Financial Officer effective upon the
      retirement of Ms. Sehman.




Ronald
      L.
      Nicholson joined KH Funding Company in 1996. He currently serves as the Vice
      President of Accounts and Loan Administration.




Martin
      Angeli joined KH Funding Company in 2003. He currently serves as the Senior
      Vice
      President of National Sales and Broker Dealer relationships. Mr. Angeli has
      been
      licensed since 1989 and has extensive experience as an NASD registered
      representative. He has previously held positions as Vice President at State
      Bond
& Mortgage, Senior Vice President at Smith Barney and Vice President at
      Oppenheimer & Co. and Merrill Lynch. He attended Simon Bolivar and
      Metropolitan University in Caracas, Venezuela where he earned a Bachelor in
      Business Administration.




Jack
      H.
      Breskow has served as a director of KH Funding Company since its incorporation
      in 1994. Mr. Breskow is an executive officer of Jack H. Breskow and Associates,
      Ltd., which provides business, estate and financial planning services to its
      clients. He is a Certified Life Underwriter and Accredited Estate Planner.




Dr.
      Mervyn Feldman has served as a director of KH Funding Company since 1998. Dr.
      Feldman maintains an active medical practice specializing in podiatry. He
      attended Wilson Teachers College and the Pennsylvania College of Podiatric
      Medicine.




-42-




Alvin
      Shapiro has served as a director of KH Funding Company since 2004. Mr. Shapiro
      is president of an actuarial firm which specializes in small business pension
      plans. Mr. Shapiro is a stockbroker, has his Series 6 license and has insurance
      industry designations of CLU and CHFC. Mr. Shapiro has a MBA from John Hopkins
      University and a Bachelors of Science in Finance from American
      College.




Jeremiah
      P. Connor has served as a director of KH Funding Company since 2004. Mr. Connor
      is currently a partner of Connor & Assoc. CPA's, P.C. 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.




We
      do not
      have employment agreements with any of our employees. We do not maintain
      director and officer insurance.




*Board
      of Directors* .
      At
      December 31, 2006, we had five members of our Board of Directors, who are
      elected to annual terms and until their successors are elected and qualified.
      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, officers or key employees.




*Committee
      of the Board* .
      The
      Board of Directors has established one standing committee to assist it in
      carrying out its responsibilities, namely the Audit Committee. 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. However,
      should the circumstances change, the Board may form a Nominations Committee
      and/or Compensation Committee in the future. As of the Record Date the
      composition and other information regarding the Audit Committee was as
      follows:




Currently,
      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.




*Audit
      Committee* .





Number
                of Members:
            
            ThreeMembers:
            
            Jeremiah
                Connor - Chairman, Alvin Shapiro and Robert L. HarrisNumber
                of Meetings in 2006:
            
            FourFunctions:
            
            ·Recommends
                to the Board the independent registered public accounting firm each
                year
                and approves the compensation and terms of their engagement
              
              ·Examines
                the scope and extent of the audit conducted by the independent public
                accountants and to advise the Board with respect thereto
              
              ·Reviews
                the recommendations of the independent public accountants with respect
                to
                accounting methods and internal controls, and to advise the Board
                with
                respect thereto
              
              ·Reviews
                the annual audit report of our independent accountants and reports
                of
                examinations by our regulatory agencies
              
              ·Performs
                such other functions and responsibilities as may be assigned by the
                BoardCharter
            
            The
                Audit Committee operates pursuant to a charter that was adopted by
                the
                Board in March 2004.




-43-




*Audit
      Committee Financial Expert* .
      Rules
      adopted by the Securities and Exchange Commission (the "SEC") require that
      we
      disclose whether our Board of Directors has determined that our Audit Committee
      includes a member who qualifies as an "audit committee financial expert" as
      that
      term is defined in the SEC's rules. To qualify as an audit committee financial
      expert under the SEC's rules, a person must have a relatively high level of
      accounting and financial knowledge or expertise which he or she has acquired
      through specialized education or training or through experience in certain
      types
      of positions. The Board of Directors has determined that Messrs. Connor and
      Shapiro are each an "audit committee financial expert" as that term is defined
      in Item 407 of Regulation S-B and by the listing standards of the American
      Stock
      Exchange. Both Messrs. Connor and Shapiro satisfy the independence requirements
      of the American Stock Exchange.




*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 will be
      provided without charge to any person upon request. Requests for copies of
      our
      Code of Ethics should be sent by mail to Corporate Secretary at KH Funding,
      10801 Lockwood Drive, Suite 370, Silver Spring, Maryland 20901. Requests may
      also be made by calling KH Funding Company at (301) 592-8100.





*Indemnification
      of Directors and Officers.* Our
      by-laws provide for the indemnification of our, directors, officers, employees,
      and agents, under certain circumstances, against attorney's fees and other
      expenses incurred by them in any litigation to which they become a party arising
      from their association with or activities on behalf of the Company. We will
      also
      bear the expenses of such litigation for any of its directors, officers,
      employees, or agents, upon such persons promise to repay us if it is ultimately
      determined that any such person should have not been entitled to
      indemnification. This indemnification policy could result in substantial
      expenditures by us, which we may be unable to recoup.




**ITEM
      9.**  **EXECUTIVE
      COMPENSATION**




***Summary
      Compensation Table***




The
      following table sets forth the compensation earned during the fiscal year ended
      December 31, 2006 by our Chief Executive Officer. Other than the Chief Executive
      Officer, no named executive officer earned a total annual salary and bonus
      in
      excess of $100,000 during the fiscal year ended December 31, 2006.





Name
                and Principal Position
            
            Year
            
            Salary
              ($)
            
            Bonus
              ($)
            
            Option
                Awards
              ($)(1)
            
            All
                Other Compensation ($)(2)
            
            Total
                ($)Robert
                L. Harris
              President
                and Chief Executive Officer and Director
            
            
            2006
            
            
            123,900
            
            
            2,283(3
            )
            
            4,715
            
            
            ─
            
            
            130,898___







(1)
      During
      the year ended December 31, 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, 2006 in accordance with FAS 123(R) of awards
      pursuant to the Plan and thus include amounts from awards granted in and prior
      to 2006. Assumptions used in the calculation of this amount are included in
      footnote I to the Company’s audited financial statements for the fiscal year
      ended December 31, 2006 included in this Report.




-44-





**Outstanding
      Equity Awards at Fiscal Year-End**





The
      following table sets forth for our named executive officer in the above Summary
      Compensation Table certain information regarding e quity
      awards outstanding as of December 31, 2006 .




Number
                of Securities Underlying
              Unexercised
                OptionsName
            
            Exercisable
              (#)
                (1)
            
            Unexercisable
              (#)
                (1)
            
            Option
                Exercise Price ($)
            
            Option
                Expiration DateRobert
                L. Harris
            
            
            ─
            
            
            150,000
            
            
            $3.30
            
            
            9/30/2009







(1)
              [The
                  options shown were granted under 2005 Equity Incentive Plan and
                  become
                  exercisable in three equal annual installments commencing one year
                  after
                  the grant date.




***Director
      Compensation***




Non-employee
      directors received a maximum of either (i) $200 or (ii) an outright grant of
      100
      shares of the Company's Common Stock, for each Board meeting attended. No
      additional fees are paid for attendance at any Committee meetings. The Chief
      Executive is also a director and serves on the board without
      compensation.




**Director
      Summary Compensation Table**




The
      table
      below summarizes the compensation paid by the Company to non-employee Directors
      for the fiscal year ended December 31, 2006 as described above.




Name
            
            Fees
                Earned or
              Paid
                in
              Cash
              ($)
            
            Stock
              Awards
              ($)
            
            Total
              ($)Jack
                H. Breskow
            
            
            ─
            
            $
            6,600
            
            $
            6,600Dr.
                Mervyn Feldman
            
            
            ─
            
            $
            5,100
            
            $
            5,100Alvin
                Shapiro
            
            
            ─
            
            $
            1,800
            
            $
            1,800Jeremiah
                P. Connor
            
            $
            1,000
            
            
            -
            
            $
            1,000Jin
                S. Kim, who resigned in March of 2006
            
            
            ─
            
            $
            5,100
            
            $
            5,100Solomon
                Kaspi, who resigned in March of 2006
            
            
            ─
            
            $
            1,500
            
            $
            1,500





-45-




**ITEM
      10.**  **SECURITY
      OWNERSHIP OF CERTAIN BENEFICIAL OWNERS, DIRECTORS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS**




The
      following table sets forth information with respect to the beneficial ownership
      of our Common Stock as of March 15, 2007 for:




·
            each
                person who we know owns beneficially more than 5% of our Common Stock,




·
            each
                executive officer,




·
            each
                of our directors, and




·
            all
                of our executive officers and directors as a group.




The
      number of shares beneficially owned by each stockholder is determined under
      rules promulgated by the SEC. The information does not necessarily indicate
      beneficial ownership for any other purpose. Under these rules, the number of
      shares of Common Stock deemed outstanding includes shares issuable upon exercise
      of options held by the respective person or group which may be exercised within
      60 days after March 15, 2007. Further, such beneficial ownership includes
      securities owned by or for the spouse, children or certain other relatives
      of
      such person 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. Beneficial ownership may be disclaimed as to certain of the
      securities.




Our
      Common Stock is privately held and there is no public trading market for our
      Common Stock. The addresses for our executive officers and directors are that
      Funding Company which is 10801 Lockwood Drive, Suite 370, Silver Spring,
      Maryland 20901.





**Name
                and Position**
            
            **Number
                of**
              **Shares(1)**
            
            
            **Percent
                of**
              **Class**Robert
                L. Harris, President, CEO and Director
            
            675,000
            (1)
            
            22.1
            %Jack
                H. Breskow, Director
            
            39,700
            (2)
            
            1.3
            %Jeremiah
                P. Connor, Director
            
            -
            
            
            -
            %Dr.
                Mervyn Feldman, Director
            
            97,478
            (3)
            
            3.2
            %Solomon
                Kaspi, r(6)
            
            500,500
            
            
            16.4
            %Jin
                S. Kim, (6)
            
            516,700
            
            
            17.0
            %Alvin
                Shapiro, Director
            
            600
            
            
            0.0
            %Martin
                Angeli, Senior V.P.
            
            102,300
            (4)
            
            3.4
            %Doug
                K. Kelly, (6)
            
            255,005
            
            
            8.4
            %James
                E. Parker, CFO
            
            11,250
            (5)
            
            0.4
            %Richard
                A. Allen , (6)
            
            178,000
            
            
            5.8
            %All
                Directors and Executive Officers as a Group (7 persons)
            
            926,328
            (7)
            
            30.4
            %







(1)
            Includes
                (i) 465,000 shares of Common Stock held directly (100,000 shares
                of which
                secure a loan receivable of $185,450 owed to KH Funding) and (ii)
                options
                to purchase 210,000 shares of Common Stock, which are exercisable
                currently or within 60 days of the table date.




(2)
            Includes
                37,500 shares of Common Stock held by his wife, Eufrosene
                Breskow.




-46-




(3)
            Includes
                95,778 shares of Common Stock held with his wife, Harriet Feldman,
                as
                tenants by the entirety.




(4)
            Includes
                options to purchase 100,000 shares of Common Stock, which are exercisable
                currently or within 60 days of the table date.




(5)
            Includes
                options to purchase 11,250 shares of Common Stock, which are exercisable
                currently or within 60 days of the table date.




(6)
            Person(s)
                can be contacted by mail c/o KH Funding Company, 10801 Lockwood Drive,
                Suite 370, Silver Spring, MD 20901




(7)
            Includes
                options to purchase 321,250 shares of Common Stock, which are exercisable
                currently or within 60 days of the table
                date.




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




*Transactions
      with Related Parties* .
      As of
      December 31, 2006, Robert L. Harris, our Chief Executive Officer, was indebted
      to the Company in the aggregate principal amount of $667,185 as a result of
      two
      loans made to Mr. Harris in prior years for purchasing Company stock and one
      loan in lieu of salary. During the year ended December 31, 2006, Mr. Harris
      paid
      all interest due on these loans and a modest amount of principal. These loans
      were made on substantially the same terms and conditions as those made to
      unrelated parties, including interest rates, which ranged from 5.99% to 7.50%
      per annum.




We
      also
      sell our investor Notes to related parties in the ordinary course of our
      business on the same terms as are available to purchasers in our public offering
      of Notes. At December 31, 2006, there were outstanding $2,912,838 in principal
      amount of investor Notes held by officers, directors, and holders of 5% or
      more
      of our common stock.




At
      December 31, 2006, there is a loan of $185,450, shown on the Balance Sheet
      as a
      contra-equity, due from Robert L. Harris, our Chief Executive Officer, for
      the
      purchase of 100,000 shares of our common stock. The interest rate on this loan
      is 7%. The stock has a book value of about $52,000 as of December 31, 2006.
      At
      December 31, 2006, there was no accrued interest receivable on this
      loan.




We
      believe that each transaction with a related party was on terms as favorable
      as
      could have been obtained from an unrelated party. All transactions between
      us
      and any of our directors, executive officers or stockholders known to us to
      own
      beneficially more than 5% of our common stock, or any member of the immediate
      family of any of those persons, or other entities in which such persons
      beneficially own more than 5%, will be entered into on terms as least as
      favorable as could be obtained from unaffiliated independent third parties.
      Such
      determination is made by our independent directors.




*Director
      Independence.* All
      of
      our current directors, except for Robert L. Harris, our Chief Executive Officer,
      are independent as that term is defined by Section 121A of the American Stock
      Exchange listing standards.




**ITEM
      12.**  **EXHIBITS**




The
      following exhibits are filed with or incorporated by reference into this
      report.




3.1
            Articles
                of Incorporation of KH Funding Company (Incorporated by reference
                from
                Exhibits to our Registration Statement on Form SB-2, Registration
                File No.
                333-106501)




3.2
            Articles
                of Amendment of KH Funding Company (Incorporated by reference from
                Exhibits to our Registration Statement on Form SB-2, Registration
                File No.
                333-106501)




3.3
            Bylaws
                of KH Funding Company (Incorporated by reference from Exhibits to
                our
                Registration Statement on Form SB-2, Registration File No.
                333-106501)




10.1
            1998
                Stock Incentive Plan (Incorporated by reference from Exhibits to
                our
                Registration Statement on Form SB-2, Registration File No.
                333-106501)




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10.2
            Selling
                Agreement by and between KH Funding Company and Capital Financial
                Services
                Inc. (Incorporated by reference from Exhibits to our Registration
                Statement on Form SB-2, Registration File No.
                333-117038)




10.3
            2005
                Equity Incentive Plan (Incorporated by reference from Exhibit 10.3
                to our
                Registration Statement on Form SB-2, Registration File No.
                333-1241155)




10.4
            Selling
                Agreement by and between KH Funding Company and Spencer Edwards,
                Inc.




10.5
            Selling
                Agreement by and between KH Funding Company and CapWest Securities,
                Inc.




23
            Consent
                of Independent Registered Public Accounting
                Firm.




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




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




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




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




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




As
      our
      independent registered public accounting firm for 2005 and 2006, Stegman &
Company provided various audit and other services for which we were billed
      for
      fees as further described below. Except as described below, under its current
      procedures the Audit Committee specifically pre-approves all audit services
      and
      other services provided by our accountants. In the case of tax services and
      other permissible non-audit services, the Committee has delegated authority
      to
      its Chairman to approve services. Any approval of additional services by the
      Chairman is communicated to the full Committee at its next regularly scheduled
      meeting. The Committee also may authorize management to obtain tax services
      from
      our accountants from time to time during the year up to a specified aggregate
      amount of fees. Requests for advice in addition to that amount would require
      further approval.




Our
      Audit
      Committee has considered whether Stegman & Company's provision of non-audit
      services is compatible with maintaining its independence. The Committee believes
      that those services do not affect Stegman & Company's
      independence.




***Audit
      Fees***




For
      2005
      and 2006, Stegman & Company audited our consolidated financial statements
      included in our Annual Reports on Form 10-KSB, and it reviewed the condensed
      interim financial statements included in our Quarterly Reports on Form 10-QSB.
      The aggregate amount of fees for those services was $59,344 and $54,997,
      respectively.




Stegman
      & Company performed no audit-related services or non-audit services for us
      during 2005 or 2006.





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**SIGNATURES**




In
      accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934,
      we
      have caused this Report to be signed on our behalf by the undersigned, thereunto
      duly authorized.


Dated:
                April 6, 2007
            **KH
                FUNDING COMPANY**By:
            /s/
                Robert L. HarrisRobert
                L. Harris,President
                and Chief Executive Officer




In
      accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934,
      this
      Report has been signed by the following persons on our and in the capacities
      as
      of April 6, 2007.





**Name**
            
            **Title**/s/
                Robert L. Harris
            
            President,
                Chief Executive Officer and DirectorRobert
                L. Harris/s/
                James E. Parker
            
            Chief
                Financial OfficerJames
                E. Parker/s/
                Jack Breskow
            
            DirectorJack
                Breskow/s/
                Jeremiah A. Connor
            
            DirectorJeremiah
                A. Connor/s/
                Dr. Mervyn Feldman
            
            DirectorDr.
                Mervyn Feldman/s/
                Alvin Shapiro
            
            DirectorAlvin
                Shapiro




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**EXHIBIT
      INDEX**




3.1
            Articles
                of Incorporation of KH Funding Company (Incorporated by reference
                from
                Exhibits to our Registration Statement on Form SB-2, Registration
                File No.
                333-106501)




3.2
            Articles
                of Amendment of KH Funding Company (Incorporated by reference from
                Exhibits to our Registration Statement on Form SB-2, Registration
                File No.
                333-106501)




3.3
            Bylaws
                of KH Funding Company (Incorporated by reference from Exhibits to
                our
                Registration Statement on Form SB-2, Registration File No.
                333-106501)




10.1
            1998
                Stock Incentive Plan (Incorporated by reference from Exhibits to
                our
                Registration Statement on Form SB-2, Registration File No.
                333-106501)




10.2
            Selling
                Agreement by and between KH Funding Company and Capital Financial Services
                Inc. (Incorporated by reference from Exhibits to our Registration
                Statement on Form SB-2, Registration File No.
                333-117038)




10.3
            2005
                Equity Incentive Plan (Incorporated by reference from Exhibit 10.3
                to our
                Registration Statement on Form SB-2, Registration File No.
                333-1241155)




10.4
            Selling
                Agreement by and between KH Funding Company and Spencer Edwards,
                Inc.




10.5
            Selling
                Agreement by and between KH Funding Company and CapWest Securities,
                Inc.




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




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




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




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





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