This old Kato mechanism is one of my favorites and I think I've done more of these types of installations than any other. The same mechanism is used for both the SD40 and SD45 models. The more recent releases take a board type decoder but for the older releases you will need to get the frame milled. The Aztec Mfg. part number for a frame milled to take a small decoder is TM3002.
Little boxes like this are perfect for storing spare motor brushes, brush springs, brush caps, etc.
As this decoder does have a blue wire, I am going to follow the option of using the blue wire as the return path for the yellow function wire on rear light board.
I have replaced the stock yellow LEDs on both boards with bright white LEDs. On the rear board, I also replaced the stock 270 ohm resistor with a 750 ohm resistor. This is because with the blue wire, the signal going to the LED is going to make the LED brighter and I wanted to reduce it to be close to the same brightness as the front LED.
This photo shows how everything is laid out just prior to re-installing the motor assembly in the frame.
The wires should lay side by side and not be twisted over each other. It is also very important that none of them have gotten caught or pinched between the motor and the frame.
In conclusion, this would be a great model to try as your first wired decoder DCC install. Other currently available decoders that would fit in the pocket milled in the frame would include the Train Control Systems M1, M4, or Z2, or the Digitrax DZ125 or DZ143.