The 40-year-old saw off David Platt, Gary Megson, John Ward and former Newcastle assistant manager John Carver to get the job.
Carlisle owner Fred Story: "We had a awful lot of interest and interviewed some really good candidates. I am not going to be derogatory about some of the very high-profile `showbusiness' names we spoke to but I am confident Neil McDonald is the right man for the job.
"He has a lot of contacts in the game and a lot of people are very supportive of his career. He comes very highly recommended by Sam Allardyce at Bolton. Neil is a manager who will get a lot out of the players."
McDonald's last job was as assistant manager of Crystal Palace, a post he left when Iain Dowie joined Charlton Athletic. He was a trainee at Brunton Park until the Magpies signed him in 1983. He joined champions Everton for £525,000 five years later before moving to Oldham Athletic and Bolton Wanderers.
He was born in Willington Quay, made 190 starts for Newcastle and 18 as sub, scoring 28 goals.