There are so many times I screw up a puzzle because I put in a letter that's already there, and don't notice (especially on the really long puzzles).
ANYTHING that's an indication that a letter is already there is better than nothing! No matter what puzzle site - sudoku, other cryptogram sites, dropquotes, etc - if you can't put in a letter or a number because it already exists, it doesn't let you. It's a basic user experience piece that's missing, and seriously detracts, from the cryptogram experience.
Especially for beginners, this will really help to make the puzzles more user friendly.
I'm choosing highlighting the previous letter in pink, because if letters are going to be removed, I want to be able to easily see where the letter is being removed from so I can correct the word that they were in! (Because if one letter in a word is wrong, chances are high other letters in the word are incorrect as well). For instance, if I have "the" and then end up using an "h" somewhere else, then I'll end up with t-e. Obviously, that word is now not "the" so another letter in it must be wrong. But what if I don't notice this right away, and later in the puzzle I have "b - t"? I'll put a "u" there, making that word "but". And then maybe I'll have "y - u", so I'll make that "you". And so on - until soon the whole puzzle is completely wrong and confusing. If the "h" in "the" were highlighted to begin with, then I'd notice "the" is wrong, change the "t", and then correctly get "bar" (instead of but) and "yet" (instead of "you"). And so on and so forth.
For sheer user-friendliness and ease of use, I'm choosing the highlighting method.