Deficits in early auditory processing (EAP) are a core component of schizophrenia (SZ) and contribute significantly to impaired overall function. Here, we evaluate the potential contributions of EAP-related impairments in reading to functional capacity and outcome, relative to effects of auditory social cognitive and general neurocognitive dysfunction. Participants included 30-SZ and 28-controls of similar age, sex, and educational achievement. EAP was assessed using an auditory working memory (tone-matching) task. Phonological processing and reading Fluency were assessed using the Comprehensive Test of Phonological Processing and Woodcock-Johnson reading batteries, respectively. Auditory-related social cognition was assessed using measures of emotion/sarcasm recognition. Functional capacity and outcome were assessed using the UCSD Performance-based Skills Assessment and Specific Level of Functioning scale, respectively. fMRI resting-state functional-connectivity (rsFC) was used to evaluate potential underlying substrates. As predicted, SZ patients showed significant and interrelated deficits in both phonological processing (d = 0.74, p = 0.009) and reading fluency (d = 1.24, p < 0.00005). By contrast, single word reading (d = 0.35, p = 0.31) was intact. In SZ, deficits in EAP and phonological reading ability significantly predicted reduced functional capacity, but not functional outcome. By contrast, deficits in reading fluency significantly predicted impairments in both functional capacity and functional outcome. Moreover, deficits in reading fluency correlated with rsFC alterations among auditory thalamus, early auditory and auditory association regions. These findings indicate significant contributions of EAP deficits and functional connectivity changes in subcortical and early auditory regions to reductions in reading fluency, and of impaired reading ability to impaired functional outcome in SZ.