Will TM backup to a destination volume smaller than the source disk?

If I buy an iMac with a 650G hard disk (which is way bigger than I need), can I use TM to backup to a 500G external disk?

Yes, depending upon how much data are stored on your hard drive. Practically your TM backup drive should be at least twice the capacity of the drive it backs up because TM performs incrementally archived backups, so each hourly backup uses more space on the backup drive. This will continue until the drive has no more space remaining to perform an additional backup. At that time your options are either to erase the backup drive and start over or replace the backup drive and start over. Hence the need to have a large backup drive.
To avoid the above you can use third-party backup software that simply replaces old files with the changed new ones. This requires only a backup drive as large as the hard drive that is backed up. This method may make more sense for you unless you plan to replace the smaller backup drive with a much larger one, but it means you would not use Time Machine. However, other backup utilities have scheduling features that make the backups automatic from the user's perspective.
Backup Software Recommendations
1. Retrospect Desktop (Commercial)
2. Synchronize! Pro X (Commercial)
3. Synk (Backup, Standard, or Pro)
4. Deja Vu (Shareware)
5. Carbon Copy Cloner (Donationware)
6. SuperDuper! (Commercial)
7. Intego Personal Backup (Commercial)
8. Data Backup (Commercial)
9. SilverKeeper 2.0 (Freeware)
10. Tri-Backup (Commercial)
Visit The XLab FAQs and read the FAQ on backup and restore. Also read How to Back Up and Restore Your Files.

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