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I thought the levels were going to be hosted online and you would just play it from there. Maybe i have the wrong idea of it though.

There's not really any such thing. Custom content in any game has to be downloaded from the server before it can be played, and then the only communication that goes on afterward is basically "I am at these coordinates now. I am doing this now. etc." It's just like a webpage -- even though the page is hosted on a server, it needs to be downloaded to your computer before you can view it.

Whether the level stays on your harddrive afterwards or not is up to the game. From what it sounds like, LBP will give you the option early on whether or not you want to keep it.