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Give yourself the breathing room and go for the smaller house. Then down the road you can decide to sell and upgrade to the bigger house, or expand. If this is your first home you don't want to go to the top of your budget because I promise you expenses always end up more than you first think. The only situation I would think the bigger house makes sense is if the market for that size house is weak right now and you're getting a uniquely good value.
I would go with option #1, not only because it is cheaper, but does anyone really need anymore space than that? It just allows more space to accumulate unneeded junk and further separate families. Plus a smaller home forces families to spend more time outdoors rather then spending all there time cooped up inside. I never understood the need for a 3000+ square foot house with multiple living/dining areas and game rooms/movie rooms and all that. Its not to say the smaller house can't be fixed up very nicely, I just don't see the need for a huge house. I know a lot of people will disagree but that is my opinion. Best of luck to you!