The default for capture scratch/render files should be in user documents along with waveform cache, FCP archive, etc. These can be put in any location from system settings.
Pick a location/name a folder and and tell FC where it is.
I would also consider making a projects folder in the same location. Keep a folder for each project that will only have the project and any GFX, picts, audio, etc.
You can edit in FCP7 with all of your media on your boot drive just like you can edit H264 files in FCP7.
The question is how well will it work consistently?
Apple does not recommended editing with H264 files in FC. There are numerous posts to support this.
There are also numerous post that do not recommended editing in FCP7 with your media on your boot drive.
Can you? yes
Will it effect the performance of your machine? yes
You are free to work however you choose, but your method is not best practice, and certainly tasks your hard disk to its limit - and this would certainly impact the performance of you system. You are asking your hard disk to simultaneously do what the OS tells it to do, do what the Final Cut program tells it to do, and play the media - all at the same time.
As Apple recommends, the best workflow is to place your project (your sequences, etc.) on one disk, and your media (your camera files, audio files, still images, graphics, render files, etc) on an external drive. From the manual:
If you are concerned about archiving each project to include all the media and/or render files, when you complete the project you can use Media Manager to consolidate all your elements and project parts into a single location and then archive that.
You can find more information about the Media Manager in the manual: