Hard Drive Partition

Hopefully you can assist me with my question below...sorry about all the details...I guess in this situation more detail is better!

I have a Pentium III 850 Mhz desktop that I upgraded from Windows ME to Windows XP Pro a few
months ago. This weekend I installed an additional 80 gig 7200 RPM Hard drive (2nd hard drive),
but I am having a difficult time deciding and finding out which way I should format and partition
the hard drive?

The original hard drive (C Drive) is a 40 gig (FAT 32)...with a small partition from the manufacturer
running the operating system (originally ME, now XP) and the other partition for personal files
and documents. The reason I am installing the 2nd hard drive is to use it to for my personal
files and documents. I would then use the original hard drive (C Drive) to only run the operating
system. In addition, I will be adding an external USB II hard drive as a backup for my personal
files and documents (as a precaution) because I have lost documents too many times if a hard
drive failed, so I would like to cover myself as much as possible.

Do you recommend running upgraded version of Windows XP on FAT32 or NTFS? I do not fully
understand what the benefits/drawbacks - positives/negatives are of either file system?
Reliability? Please assist me?

BACKGROUND INFORMATION:
-The computer is running the C: drive (original manufacture drive) on FAT32.
-The second hard drive is physically installed in the case, but is not yet formatted/partitioned.
-Currently running 128MB PC100 SDRAM, but after successful hard drive install I have two 256
sticks standing by to max out (512MB) RAM.
-CD-RW (bay)
-DVD Player (bay)
-Floppy (bay)
-modem (pci)
-ethernet card (pci)
-sound card (built in)
-video card (built in)
-two empty pci slots left
-one bay open for only enough room for internal zip drive
Tech: Make/MODEL - COMPAQ Presario 5BW284

OTHER:
I understand that Fat32 under Windows XP can only partition up to 32 gigs...however, I read
somewhere that there is a way to use some files from previous versions of Windows (ie. ME) to run
in Windows XP and partition more than 32 gigs of hard drive in FAT32 - BUT - I do not know
where/what it is? Is it recommended to format/partition the original Hard drive and the new one
to NTFS? What does formatting and partitioning a hard drive do? (Meaning splitting the large space up?)

Thank you for all your assistance!