AF 4-4-2 #545

Does your loco have a smoke unit? Because the smoke unit needs smoke fluid or else it'll burn out and have to be replaced. Also, old trains do give off a smell called ozone. Also the commutator could be dirty and the brushes might need replaced. Here's a guide to cleaning and maintaining old American Flyer and Lionel trains 

Do you know the era the train was from, in other words when your grandfather owned it? From what you are describing it sounds like a prewar train meaning it was built before WW2. Not exactly my area of expertise. However, from what you describe the lever is probably what reverses the train. You might want to repost this in the tinplate forum with pictures of the locomotive to try to first identify the train before tinkering with it.  Also if you plan on taking the train apart for cleaning or repair make sure to photograph how everything fits together and be careful not to lose or break any parts since they might be hard to come by with American Flyer having been out of business since the sixties.

Speaking from my own experience, that burning smell may be the result of old insulation on the wires, crumbling off.  You could be asking for trouble if you keep running it without finding out for sure.  I suggest having the locomotive looked at by someone with some experience in this area.