If you choose to run your homebrew apps from SD card, then yes: it has to be in the system. But you can always get another SD card (up to 32gig) to do your normal day-to-day things (2gig max was only needed for the modding process itself).
I (and most of the staff) would recommend that you format your hard drive as FAT32 (and you will definitely want to get something other than a 3.6gig stick). We have a FAT32 guide that shows you how we recommend you format and install content. The properly installed content will be stripped as .wbfs files and will vary in size depending on the game (lowest I know is 32meg, highest is 8.5gig).
There are two methods to USB loading GameCube content. Dios Mios and Devolution. I prefer DM myself, but I think most of the rest of the staff uses Devolution. The hard drive has to be FAT32 formatted with 32k clusters for this to work (the guides will show you how to detect and modify this setting).
All guides mentioned assumes you started with Softmod Any Wii guide and are all linked in my signature.