I'd get the small house. . .I think now is a good buying opportunity and you need to start becoming upwardly mobile.
If you keep saving and saving, you have to beat inflation consistently to get the downpayment needed.
However, that being said, I wouldn't do it if you only plan to be in the small house 3 years or less. . .if you plan 4-7 years, then go ahead and buy the small house and get the appropriate mortgage.
EDIT: Not to sound old-fashioned, let me apply one caveat - I would not buy anything until vows are exchanged. . .you don't want to have to sell a house during a break-up. So, if you are not scheduled to be married until 2009. . .just keep saving.
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