Up until the point where you wake up with marks and scratches. I bet the general population would think something supernatural is at work if you wake up with marks while dreaming about demons. It was more fun when I didn't know if demons were at work, or it were just disturbed. By removing that uncertainty, you removed certain tension... so I would like it better if it sleep-deprived just because of my horrifying nightmares.
I think it's silly to think that you'll find your brother at last. Keeping with the topic of uncertainty, you could make the reason of going back to the woods vague; maybe you hope to find your brother, but that's not enough. Maybe you want to find an answer to your nightmares, or maybe you just are desesperate and don't know what else to do. But all this uncertainty would turn this into a mystery game, and maybe you are going for straight horror.
I agree with a lot of your points here, the plot is very under-developed, and needs work. But I'm no writer, and I'm out shape as far as game design goes if you know what I mean. I agree being inspired by a nightmare is sort of silly, along with the scratches which are sort of "that edge I don't really need" plot wise.
Also, on the whole mystery vs. horror thing, what I'm trying to go for is, haha, maybe, horror that's actually scary? Which is what I meant by atmospheric, I'm trying to build up tension. And if I dare embark on such an adventure as making this game and it ends up with lackluster graphics, I still want to find a way to make put in horror.
But then again, plat-formers can be creepy, can they not? (example: Amon26's Au Sable)
And yes, eternal darkness was a wonderful game, a large inspiration.