Free Water Imaging is a novel diffusion magnetic resonance (MR) imaging method that is able to separate changes affecting the extracellular space from those that reflect changes in neuronal cells and processes. A previous Free Water Imaging study in schizophrenia identified significantly greater extracellular water volume in the early stages of the disorder; however, its clinical and functional sequelae have not yet been investigated. Here, we applied Free Water Imaging to a larger cohort of 63 first-episode patients with psychosis and 70 healthy matched controls to better understand the functional significance of greater extracellular water. We used diffusion MR imaging data and the Tract-Based Spatial Statistics analytic pipeline to first analyze fractional anisotropy (FA), the most commonly employed metric for assessing white matter. This comparison was then followed by Free Water Imaging analysis, where two parameters, the fractional volume of extracellular free-water (FW) and cellular tissue FA (FA-t), were estimated and compared across the entire white matter skeleton between groups, and correlated with cognitive measures at baseline and following 12 weeks of antipsychotic treatment. Our results indicated lower FA across the whole brain in patients compared with healthy controls that overlap with significant increases in FW, with only limited decreases in FA-t. In addition, higher FW correlated with better neurocognitive functioning following 12 weeks of antipsychotic treatment. We believe this is the first study to suggest that an extracellular water increase during the first-episode of psychosis, which may be indicative of an acute neuroinflammatory process, and/or cerebral edema may predict better functional outcome.