1. You could use 3 1/2" but I'd want to add a bit because the thread does take up a bit of space. I'd probably add an 1/8".
2. You need to add 7/8" to the finished size, so 3/8" to the unfinished size would work. Again, some of us prefer to add an extra 1/8" and then trim down, but that's personal preference.
3. I have no idea - sorry!
Does your Babylock have a locking stitch? My Janome does and that makes it easy but if it didn't I'd use the smallest setting.