Costello was born in Auckland, the second son of what was to become a family of six children. His father Christopher had been born in Dublin in 1867 and gone to Australia, probably in 1887, where he met and married in 1905 Mary Woods, born in Melbourne in 1885. She was the daughter of Irish-born Patrick and Elizabeth Woods, whose family in County Kilkenny in Ireland Paddy Costello later visited frequently.
After they were married Christopher and Mary went to Auckland, where he became a grocer and the family lived over or behind the various shops he ran until his death in 1923. Most of these were in the middle-class suburb of Devonport, where Costello started school at the local Catholic school. He later transferred to Ponsonby school, possibly because the scholarship he sought was available only to children at state schools. In any event he won the scholarship and went to Auckland Grammar School and passed his university entrance examination in 1927, aged only 15. From 1928 until 1931, on more scholarships, he attended the Auckland University College of the University of New Zealand, completing his BA in 1930 and MA in 1931 with first class honours in Greek and Latin.
In 1932 Costello was awarded a postgraduate arts scholarship and went to Cambridge, where he attended Trinity College until 1934, graduating with first class honours in the classical tripos. He was elected a scholar of Trinity and won a research studentship for a year at the British School at Athens. Already fluent in French, German, Italian, Spanish and Greek, he would later learn Gaelic, Russian and Persian.

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