McMurtry was born in Archer City, Texas, the son of Hazel Ruth (née McIver) and William Jefferson McMurtry, who was a rancher. He grew up on a ranch outside Archer City, Texas, which is the model for the town of Thalia that appears in much of his fiction. He earned degrees from North Texas State University (B.A. 1958) and Rice University (M.A. 1960).

McMurtry has won the Jesse H. Jones Award from the Texas Institute of Letters on three occasions; in 1962, for Horseman, Pass By; in 1967, for The Last Picture Show, which he shared with Tom Pendleton's The Iron Orchard; and in 1986, for Lonesome Dove. He has also won the Amon G. Carter award for periodical prose in 1966, for Texas: Good Times Gone or Here Again?.In 1964 he was awarded a Guggenheim grant. In 1960, McMurtry was also a Wallace Stegner Fellow at Stanford University, where he studied the craft of fiction under novelist Wallace Stegner and alongside a number of other writers, including Ken Kesey, Peter S. Beagle, Robert Stone, and Gordon Lish. McMurtry and Kesey remained friends after McMurtry left California and returned to Texas, and Kesey's famous cross-country trip with his Merry Pranksters in a day-glo painted schoolbus 'Further' included a stop at McMurtry's home in Houston, described in Tom Wolfe's New-Journalistic book The Electric Kool-Aid Acid Test.

While at Stanford he became a rare-book scout, and during his years in Houston managed a book store there called the Bookman. In 1969 he moved to the Washington, D. C. area, and in 1970 with two partners started a bookshop in Georgetown which he named Booked Up. In 1988 he opened another Booked Up in Archer City, which is one of the largest single used bookstores in the United States, carrying somewhere between 400,000 and 450,000 titles. Citing economic pressures from Internet bookselling, McMurtry came close to shutting down the Archer City store in 2005, but chose to keep it open after an outpouring of public support.

McMurtry has been a regular contributor to The New York Review of Booksand is a past president of PEN. He is perhaps best known for the film adaptations of his work, especially Hud (from the novel Horseman, Pass By), starring Paul Newman and Patricia Neal; the Peter Bogdanovich directed The Last Picture Show; James L. Brooks's Terms of Endearment, which won five Academy Awards, including Best Picture (1984); and Lonesome Dove, which became a popular television mini-series starring Tommy Lee Jones and Robert Duvall.

In 2006, he was co-winner (with Diana Ossana) of both the Best Screenplay Golden Globe and the Academy Award for Best Adapted Screenplay for Brokeback Mountain. He accepted his Oscar wearing jeans and cowboy boots along with his dinner jacket and used his speech to promote books by reminding his audience that "Brokeback Mountain" was a short story by E. Annie Proulx before it was a movie. In his Golden Globe acceptance speech, he paid tribute to his Swiss-made Hermes 3000 typewriter.

His son, James McMurtry, is a singer/songwriter and guitarist. His former wife Jo Scott McMurtry, an English professor, is also the author of five books.