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Updating you pipe is a viable solution to galvanized pipe any day, question is is it worth your time. Depends on how long you plan on staying in the house, It might help the resale value also!
As with any pipe in a space that can freeze you should have heat tape on all the exposed pipe, insulate it with a pipe insulation, keep all extreme cold from the bare metal pipe. Typically you would have bare pipe on the warm side of the insulation in the floor and walls, this would be enough to prevent freezing. But in older homes you don't have the luxury of this standard practice.

On the bypass thing, You should have the pipe from the street to a valve, from the valve you should have one pipe leading to the inlet/cold side of the water heater and the other side of the pipe going to your cold on the house supply. The hot from the water heater should be feeding the hot water pipes in your house. If you have a cold water pipe feeding into your hot water line coming out of your hot water heater then you are defeating the purpose of hot water.

16x80