Your overheat problem would likely be cured by reverting back to clutch fan.. Many are,, there are several threads related,, do a search for "overheat" under the " heating/cooling" forum,, there are numerous posts...
The by-pass hose goes to the suction side of the pump, as does the heater hose..
The function of the b/pass hose is to keep water circulating in the block while the t/stat is closed, preventing potential localized hotspots,, this also helps warm and circulate water to the heater sooner, before the t/stat opens, and all the cold stagnant coolant (rad) is warmed..
hope it helps