I'll second Schoonerbum's comments - with particular emphasis on the fact that all these decisions are the individual modeler's to make. I like the idea of marking the waterline - whether or not you remove the (admittedly out of scale) planking detail below it.
Marking a waterline on a model like this is a little tricky - but it's a whole lot easier at this stage, before the hull halves are glued together. The problem is that the waterline has to be straight and horizontal. If it sags, bulges, wavers, or tilts, the appearance of the finished model will be seriously damaged. Careful, considerate kit designers mold the waterline into the hull halves, in the form of an extremely fine raised line. Looks like the Lindberg folks didn't do that.
To mark a waterline you need to rig up some sort of jig with either a pencil or a scriber attached to it. The traditional method is to set the hull, which is fastened to some sort of base so it's guaranteed to be absolutely upright, in the middle of a flat surface like a table top. The jig can be as simple as a wood block of the appropriate height with the pencil or scriber taped on top of it. Since your hull halves haven't been assembled yet, you might want to fasten them to a wall (maybe using double-sided tape), or perhaps lay them flat on the table, with the pencil held vertically in some sort of simple gadget that can slide it over the hull half. In any case, having the hull halves separate lets you compare them with each other easily.
Here's a picture of a finished model of the Wappen von Hamburg:
http://www.modelexpoonline.com/cgi-bin/sgin0101.exe?FNM=06&T1=SM28&UID=2006021312160783&UREQA=1&TRAN85=N&GENP=
I'm not endorsing this particular model; it was built from one of those continental European plank-on-bulkhead kits that I've railed against at such disgusting length in this Forum. But the waterline does look like it's in the right place.
Most of the work in marking a waterline goes into getting ready. A little ingenuity and half an hour's work should produce a perfectly satisfactory jig. (You can also buy one from Model Expo, but that sure seems like a waste of money.) The actual marking job takes a couple of minutes.
As we've discussed before, the hull below the waterline might be coated with "white stuff," "brown stuff," or "black stuff." The planking between the waterline and the lowest wale might be tarred, as Schoonerbum suggested, in which case that planking probably would be about the same color you've used for the wales. Or it might be oiled and stained like the rest of the hull planking - the same color as the planking between the wales.
While you're working on the individual hull halves you might want to give some thought to another topic: the mounting of the finished model. If you want to put it on pedestals, or some other centerline-mounting method, now's the time to figure out how you're going to do it. You may want to shape a piece of wood, with holes for screw in it, to fit inside the hull. Or epoxy a couple of nuts in appropriate positions to receive bolts running up through the base. In any case, if you make some provision to hold the model solidly onto a base you'll thank yourself later - both while you're working on it and when it's finished.
Good luck. This is shaping up to be a mighty nice model.