Davies was born in Liverpool to working-class Catholic parents, the youngest child in a family of ten children (seven surviving). After leaving school at sixteen, he worked for ten years as a shipping-office clerk and as an unqualifed accountant, before leaving Liverpool to attend Coventry Drama School. While there, he wrote the screenplay for what became his first autobiographical short, Children (1976), filmed under the auspices of the BFI Production Fund. After this introduction to filmmaking, Davies went to the National Film School, completing Madonna and Child (1980), a continuation of the story of Davies' alterego, Robert Tucker, covering his years as a clerk in Liverpool. Three years later, he completed the trilogy with Death and Transfiguration (1983), in which he hypothesizes the circumstances of his death. These works went on to be screened together at film festivals throughout Europe and the U.S. as The Terence Davies Trilogy, winning numerous awards.

Due to funding difficulties and his refusal to compromise, Davies' output has been comparatively sporadic, with only four feature films released to date. The first two, Distant Voices, Still Lives and The Long Day Closes, are very autobiographical films set in 40's and 50's Liverpool; his two most recent films, The Neon Bible and The House of Mirth, are adaptations of novels by John Kennedy Toole and Edith Wharton, respectively.

At the time of writing, his intended fifth feature, Sunset Song, an adaptation of the novel by Lewis Grassic Gibbon, has fallen through. Scottish and international backers left the project after the BBC, Channel 4, and the UK Film Council each rejected proposals for final funds. Davies supposedly was considering Kirsten Dunst for the lead role before the project was postponed.

His most recent work in any medium is A Walk To The Paradise Gardens, a radio play broadcast on BBC Radio 3 in 2001.