Regarding LIVE, a mod chip can be disabled to allow you on LIVE, but you have to be using original game discs, of course. Backups or games copied to the hard drive won't work with LIVE and when you connect to LIVE using one you will be banned. So, if you don't plan on actually purchasing legitimate copies of games for this thing, don't let LIVE factor into your decision.
Additionally, setting up a hard drive can be a pain in the ass. I HIGHLY recommend a program called AvaNetPrepare. It's made by the team that makes the Avalaunch dashboard. It's incredibly easy to set up and it automates the process of formatting/partitioning the new drive as well as cloning the old drive over.
However, for a 20 GB drive, I'm not sure putting in a new drive is worth the hassle. It probably already has a 10 GB drive, which will hold all the old classics. Once you get into N64 and PSX emulation you need a bigger drive anyway.
You can probably get an 80 GB drive for $30. Not only is it convenient to load Xbox games directly from the hard drive, it actually makes games better by substantially reducing load times. Additionally, with a hard drive you can just pop a disc in and rip it directly to the Xbox. I believe ripping a game to an ISO on a PC and then burning it to a disc is MUCH more complicated, not to mention that many games will only fit on a dual layer DVD+R so you either have to buy the still very expensive dual layer blanks, or you have to reauthor the game, stripping out non-important parts, which I don't even know how to do. And I might as well throw in one more "not to mention". Not to mention that Xbox DVD-ROM drives are famous for being finicky about media. Finding a brand and format (+r vs. -r) that works in your Xbox's drive can be an expensive exercise in frustration. You buy a spindle of Verbatim +R's only to find they don't work, so you buy a spindle of Memorex +R's, only to find THEY don't work, so you go with Verbatim -R's, which don't work, so you try Memorex -R's and BINGO. You've got it! . . . and a lifetime supply of blank DVD's that can't be used for your Xbox.