Now they brought the model, its theirs to do as they please with (assuming the artist has given permission.), so in that regard its okay but in terms of the game does it break it to much? potentially having every player walking around with legendary looking weapons.
Is this really a problem?
There are hundreds of potential problems that come to mind if such a system was put into a game in reality (which the penis sword problem just being #1 of them), the fact that beginners swords now could look awesome not being one of them to be honest.
If you afraid that the endgamers wouldn't like it: Given your game is popular enough, and the blacksmiths active enough, there would always be the one epic weapon that would actually look unique and epic... and the one trash beginner that would also look epic. It would give weapons another dimension other than stats... some players might choose a non-optimal weapon just because it doesn't look like the rusty beginners sword.
Let me tell you, the beginners would be THRILLED not having to walk around in rags until level 30!
If you are afraid the whole thing would break the story or atmosphere of your game, then chuck player customization out of the window now. Its a fact most of your players, especially in online games, don't give a damn about your story. If you want to force them to roleplay, you should limit customization. If you want to give them the max ability to customize, let go of some control. Let them have their beginners sword of epicness, and their master epic weapon deceivingly looking like a rusty noob dagger thingy.
If it will annoy some people, it will also amuse just as many others.