Borntoquilt,
Question 1: I do mine using your method #2: cut 2 squares 4 3/8 (3 1/2 + 7/8). Draw diagonal line from corner to corner. Sew 1/4 inch on each side of the line. Cut on the line. Press open. Voila: 2 hst 3 1/2 inches.
Question 2: Is your Babylock computerized? On my Babylock Espire, on the screen with various quilting stitches on it, some have a dot at the top of the stitch picture, some have a line at the top. The ones with the dot at the top will stitch in place when you push the reverse button. The ones with the line at the top will backstitch when you press the reverse button. Does that make sense? PM me if I can explain it better for you.
Hope this helps, without being too complicated.