I figured that completing a quest for the Temple of Baa (sigh, what a name) would result in some unwanted consequences and decided to check up on it. It turns out that it decreases reputation. I want to finish all of the quests that I come across. How can I make this reputation mechanic work for me rather than restrict my playthrough?

Reputation isn't that hard to manage. It's mostly important when you try to max out your training in Light and Dark magic, since you need really high reputation for Light magic and really low reputation for Dark magic. Fortunately, you can raise your reputation really easily by repeatedly donating to temples, so don't worry if you lower it too much. If you WANT to lower it, there are various ways to do that but I don't remember them all. One way is to cast the Armaggedon spell in a town, although I understand if you'd rather not do that.

It's definitely possible to get the highest training in both Light and Dark magic in a single playthrough.

Just do quest. About halfway through the game you'll be saintly. Get master light. Cast Armageddon, you'll be notorious. Get master dark. After this do what you want (just don't visit castles with bad rep). Also bad rep makes your characters to be rude to people, which I loved.

Also, if you're having trouble reaching Saintly and are stuck on 'Glorious' or something like that (I forgot the exact name) just go into a town and find a Bard NPC to hire, he/she will raise up your reputation by 1 no matter where you stand :)

Donating to a Temple of Baa will lower your reputation to Neutral, while donating to any other temple will raise your reputation to Respectable.

In addition to killing civilians, you can lower your reputation by:

-Completing the quest for the Temple of Baa

-Selling bones

-Robbing the graves in Castle Darkmoor

-Completing the obstacle course and then praying to Baa in the Superior Temple of Baa. (If all four of your party members do this, it could lower your reputation from Neutral to Notorious.)

-Freeing Archibald.

The easiest way to raise your reputation, I've found, is to expose the traitor on the Council; this can raise your reputation from Respectable to Saintly.

I'd say that the easiest way to become a Master of both Light and Dark magic and have a good reputation afterward would be to go through the game until you get to the part where you can enter the Superior Temple of Baa, donate to a Temple of Baa until your reputation is Neutral, pray to Baa in the Superior Temple to get Notorious reputation, learn Master-level Dark magic, donate to a non-Baa temple until your reputation is Respectable, complete the quest to expose the traitor on the Council and get Saintly reputation, and then learn Master-level Light magic.

I believe another easy way of getting to the Nororious reputation is simple to cast Armageddon once ;)

Of course, and that has already been established.

But there are other options for those who find that option too... unsavory.

Question: How much more difficult is the game if I choose not to master Dark Magic? Does this affect how I should build the party initially?

You don't need to master dark magic. I recently went through the game for my second time and I never learned it.

It's not needed no but getting Day of Protection is mighty handy if you want to save time. Also; Dragon Breath is one of best damage spells in the game imo.

I found Saintly reputation the most difficult to achieve/maintain precisely because Reputation above a certain level (Respectable?) degrades simply due to the passage of time.

If you want to learn Master Light Magic I highly recommend that you put off a bunch of quests until you have Lloyd's Beacon, Fly, and a lot of other powerful spells that will allow you to quickly complete these quests in rapid succession and then immediately cast Lloyd's Beacon to return to the Master Light Magic trainer (where you've left a beacon, of course), and learn Master Light Magic.