Alveolar epithelial type 2 cell (AEC2) dysfunction is implicated in the pathogenesis of adult and pediatric interstitial lung disease (ILD), including idiopathic pulmonary fibrosis (IPF); however, identification of disease-initiating mechanisms has been impeded by inability to access primary AEC2s early on. Here, we present a human in vitro model permitting investigation of epithelial-intrinsic events culminating in AEC2 dysfunction, using patient-specific induced pluripotent stem cells (iPSCs) carrying an AEC2-exclusive disease-associated variant (SFTPC^I73T). Comparing syngeneic mutant versus gene-corrected iPSCs after differentiation into AEC2s (iAEC2s), we find that mutant iAEC2s accumulate large amounts of misprocessed and mistrafficked pro-SFTPC protein, similar to in vivo changes, resulting in diminished AEC2 progenitor capacity, perturbed proteostasis, altered bioenergetic programs, time-dependent metabolic reprogramming, and nuclear factor κB (NF-κB) pathway activation. Treatment of SFTPC^I73T-expressing iAEC2s with hydroxychloroquine, a medication used in pediatric ILD, aggravates the observed perturbations. Thus, iAEC2s provide a patient-specific preclinical platform for modeling the epithelial-intrinsic dysfunction at ILD inception.