Waterhouse was born on 19 July 1830 in Aigburth, Liverpool, Lancashire, the son of wealthy mill-owning Quaker parents. His brothers were accountant Edwin Waterhouse, co-founder of the Price Waterhouse partnership, which now forms part of PriceWaterhouseCoopers, and solicitor Theodore Waterhouse, who founded the law firm Waterhouse & Co, now part of Field Fisher Waterhouse LLP in the City of London.
Alfred Waterhouse was educated at the Quaker Grove House School in Tottenham. He studied architecture under Richard Lane in Manchester, and spent much of his youth travelling in Europe and studying in France, Italy and Germany. On his return to Britain, Alfred set up his own architectural practice in Manchester.
Waterhouse continued to practise in Manchester for 12 years, until moving his practice to London in 1865. His earliest commissions were for domestic buildings. In executing the commission for the cemetery buildings at Warrington Road, Lower Ince (1855–56), he began his move towards designing public buildings in his developing Neo-Gothic style, building a lodge for the registrar, and two chapels, one Church of England, and one Non-conformist. His success as a designer of public buildings was assured in 1859 when he won the open competition for the Manchester Assize Courts (now demolished). This work not only showed his ability to plan a complicated building on a large scale, but also marked him out as a champion of the Gothic cause.
In 1860 he married Elizabeth Hodgkin (1834–1918), daughter of John Hodgkin and sister of the historian Thomas Hodgkin. Elizabeth was herself the author of several books, including a collection of verse and some anthologies. Her best known work was The Island of Anarchy, a Utopian story set in the late 20th century, first published in 1887 and more recently re-published by the Reading-based Two Rivers Press.
Waterhouse had connections with wealthy Quaker industrialists through schooling, marriage and religious affiliations, many of which commissioned him to design and build country houses, especially in the areas near Darlington. Several were built for members of the Backhouse family, founders of Backhouse's Bank, a forerunner of Barclays Bank. For Alfred Backhouse, Waterhouse built Pilmore Hall (1863), now known as Rockliffe Hall, in Hurworth-on-Tees. In the same village he built the Grange (1875), now the Hurworth Grange Community Centre, which Alfred Backhouse had commissioned as a wedding gift for his nephew, James E. Backhouse. Another Backhouse family mansion designed and built by Waterhouse was Dryderdale Hall (1872), near Hamsterley, used for the home of Cyril Kinnear in the film Get Carter.