Interrupts and the MSC Debugger don't get along very well together.

You must DISABLE debugging in any interrupt routines.
Code:
DISABLE DEBUG
asm
tmroverflow movwf	wsave
    ...
    ...
            retfie
ENDASM
ENABLE DEBUG
For an 877, you should use $70 for the wsave address.

OPTION_REG = %00000101 sets the prescaler to 1:64. (comment says 32)

and, like skimask said ... set the LED's pin to output.