A restore CD (also called a recovery CD by some manufacturers) is supposed to let you restore your computer to factory specifications. In other words, get it back to the exact same condition it was in on the day you brought it home. So yes, you are correct ... the hard drive will be completely erased and replaced with the data on the restore CD.
An external hard drive is an accessory you'd have to buy separately. It usually plugs into your computer via a USB port with a single cable. If it's a very large capacity external hard drive it may also have it's own power cord in addition to the USB cable. Or, many computer cases these days allow you to add an extra internal hard drive but I prefer the external because you can easily unplug it and store it safely away. Here's a sample of external hard drives offered by Dell. Don't get put off by the prices because you can find some decent holiday sale prices now at online stores like Newegg, TigerDirect, or big box stores like Walmart, Best Buy, etc.
External Hard Drives : Storage, Drives & Backup | Dell
Once the external hard drive is plugged into your computer, it should automatically be recognized and be assigned a drive letter. (Your current hard drive is probably named C: and your DVD/CD drive is probably named D: ) The new external drive might get E: assigned to it. Windows 7 comes with it's own backup utility that can let you create an entire system image or backup just individual files. Some folks don't like the Windows 7 imaging tool because it doesn't offer a lot of flexibility compared to other free software like Macrium, Paragon, EaseUS, etc.
Making a system image is pretty straight forward. With Windows 7 you'd make sure the external drive is plugged into you computer. You'd access the imaging tool (click start button > control panel > backup and restore > create system image) and pretty much follow the prompts. Just as a very general guideline I've found that it takes about 25 minutes for every 50GB of data.
Hope this helps some. If you have any other question please post back.