I think it's hard for someone on the outside to guess what choice might make you happier, but as someone who did your "option one" I can tell you a bit about what that was like.
We bought a Sub-500 square foot studio a year ago, after selling our bigger and fancier place. We wanted to lock in a low cost of living for early retirement, while staying in downtown Seattle. We paid cash (using the proceeds from our big house sale) and spent about 10% of the home's value on improvements, including new floors, new paint, some cabinetry and nice furniture including a fold-down bed to avoid the "bed in the living room" problem you get with studios. Extravagant perhaps, but if we were going to live in a tiny house we wanted it to be comfy and nice.
Then recently we sold our car. So we're car-free and living downtown in our itty bitty condo.
The Good: The financial benefits were huge. We cut our time to FIRE by at least five years, locked in low housing costs in an expensive city, and get access to all the fun/free stuff to do downtown. Having less stuff and no car has been really liberating. We're a 45min train ride from the airport and buses get us pretty much anywhere we'd like to go. Parks are our backyard and the Central Library is our bookcase. It's a fun and chill way to live - being so close to everything but not needing to own/mow/maintain stuff.
The Bad: Making these changes was pretty stressful. I was freaked out about going car free and losing my freedom. It hasn't been a big deal at all, once we made the leap. But that didn't stop me from freaking out.
I don't think this would work so well if we weren't in such a walkable city, or if we needed lots of square footage to stay sane, or if we disliked being downtown. The finance stuff is great, but there is no point in being miserable just to save money.
But we're really happy with "option one." For what that's worth. Let us know what you decide.
SIS
