When going from XP to Windows 7 there is no choice but a custom install so that is the only choice you will be offered.
Does your hard drive have more than one partition? If it has a system restore partition then you might want to drop all partitions and repartition as a single partition. Once W7 is installed you cannot use the "system partition" to return to WinXP so it is just wasted space.
I like to format the Win XP OS drive (or new partition). If the drive is not reformatted before installation then the install will attempt to create a 100mb partition for its' own use, yet if it cannot create this partition it still works fine. If WinXP is still on the drive when W7 is installed, everything on the partition gets moved to Windows.old. Mostly this folder just takes up space and you will have to Take Ownership of windows.old if you want to delete it once W7 is working.
Before you repartition or format WinXP you probably want to download and install
Windows Easy Transfer for WinXP. Then, while still in XP, you run Windows Easy Transfer and have it back up all your data & settings to a .MIG file and store it to your external drive. Then do your repartitioning or formatting. Then put in the W7 USB, set your BIOS to boot to the USB first (prior to the hard drive), and boot to the flash drive. Install Windows 7. Install all your programs. Run Windows Easy Transfer (comes preinstalled with W7) to restore your data & settings.
NOTE: If you end up repartitioning and you bought an upgrade key, it may tell you no Windows is installed (because repartitioning wiped it out). If you get this message then simply run the installation a second time and it should work fine.