HTPC has been a hobby of mine for over 7 years now so I'd love to offer my 2 cents.
I have a WHS (Windows Home Server) tucked away that is just an old P4 with a lot of drives. I love it because I have a central place to access my files from. It also provides super easy to use features to make any data I desire redundant for me. It does that without having to mess with RAID and it does it with a collection of different sized drives.
In my main HT room I have a powerful HTPC built with Win7 running MCE (built into windows by default) as the software/GUI for the TV. I've always use the spdif output and let the AVR do the conversions. Once I replace my old DLP I'll switch to HDMI but still the AVR would do all the decoding. With this box I'm able to playback nearly any audio or video format.
In my bedroom I have an Xbox 360 that's sole job is to be a front end. Using it's built in MCE Extender it connects to my HTPC and gives me the exact same GUI that I see on the HTPC. It's great for the wife because she doesn't have to learn anything new. Personally I like the MCE UI better than anything else I've come across. Again I'm using HDMI for the audio output here.
You could simplify this setup by storing all the files on the HTPC and remove the WHS. I use my WHS for more things like workstation image backups (awesome feature) and remote access from the internet. You could also add more 360s on the network to be additional extenders (which I'm going to do myself in the near future). For the HTPC I've seen people build some pretty small boxes, low power too (fan-less) using Atom processors. The options are really endless, but that can be daunting to some as well. Probably why so many people have paid me to build and set them up for them.
