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