Oh man I feel for you, I’m in a very similar position. At the end of the day it’s about what’s important to you.
Max the budget, Spend the money. Build the life we want, have the big house in the near suburb and send the kids to the best school. The risk you live week to week, no financial Secuirity.
Make the smart financial decision, choose the cheaper house Invest the rest.
Let be honest. This is not a real option. Are they your parents? You and definitely your partner don’t want to do this long term.
If you went option 1 and it didn’t work out then you could move to option 2. The other way round would be much more difficult.
Not to be rude. This ain’t a property question. More a what do you want from life question. You seem like a young couple, earning very good money (first home $2.2m).
But to answer you’re question what would I do? Option 1 for sure. Best schools, best location, your still young income will rise. If things go south revert to option 2, if things go even worse revert to option 3.