You have the possibility to choose ext2 or ext3 and some more options i guess as filesystem for the image (or even partition which is much faster). Yes, config file is located in /home/user/.chroot where you have to define path / filename and fs-type of the image / partition.
Btw, i'm using the Mer0.17testing11 image on a 5GB-partition at internal eMMC: Netbeans, Kile, Gimp, Inkscape, Abiword, Gnumeric and Dia are running well...