not as terrible as what I thought
#2 is more natural.
The alternatives are what Mycroft suggested.
The "what" would not be spoken. The full sentence, including "implied" text, "might be:
"But it's not as terrible as I thought it would be.
If "it" is a different thing altogether from the thing I was thinking about, the sentence might be:
"But it's not what I thought." or "But it's not what I thought it would be."